Buying a Home When Your Debts Are High

fall-home-exteriorCan you get a mortgage with high debt? You may have good credit, a stable income and a decent down payment. But if you also have a high debt-to-income ratio, you're right to be concerned about your mortgage approval.

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Mortgage with debt

When underwriting your mortgage application, lenders don't just consider your income. They look at the relationship between what you earn and what you spend -- your debt-to-income ratio, or DTI. If your DTI is on the high side, getting a mortgage could be a challenge.

But you may still qualify for a home loan if your application is otherwise strong.

What is a high DTI, anyway?

Your debt-to-income ratio equals your debt payments (including house payment or rent) divided by your gross (before tax) income.

There are two measures of DTI -- the first is a front-end or top-end ratio. It is the total of your monthly mortgage, property taxes and property insurance payments divided by your gross monthly income.

If you earn $8,000 per month and your mortgage principal, interest, taxes and insurance (PITI) equals $2,000 per month, your front-end ratio is 25%. That's $2,000 / $8,000.

The second measure is more important. It's called the back-end or bottom-end ratio. The back-end ratio adds your other monthly payments to the mix -- minimums on credit cards, auto loans, student loans and the like. it does not include living expenses like food and utilities.

So if your other loan payments total $1,000, your back end ratio is ($2,000 + $1,000) / $8,000. That's 37.5%. When lenders just say "DTI" or "debt-to-income ratio," they are referring to the back-end ratio. That's the key number for most mortgage programs.

What is a high DTI? Generally, programs get a little more restrictive for DTIs over 36%. You might need a better credit score or bigger down payment to qualify. But most programs will allow a high DTI -- as high as 43% for a well-qualified applicant. And some will let you go as high as 50% with the right compensating factors.

Related: How to Get Preapproved for a Mortgage

The challenge of a high DTI

Why 43%? Because mortgage lenders must comply with a provision of mortgage reform called the ATR rule -- and that means lenders must verify your Ability To Repay the loan. The government assumes that lenders have complied with this rule if they verify your income in writing and if your DTI is 43% or lower. That gives lenders some legal protections if you fail to repay the mortgage.

This doesn't mean lenders can't make loans with higher DTIs. But they are taking on additional risk in doing so. And for that extra risk, they charge higher interest rates.

You have another option if your DTI is high -- a government-backed FHA mortgage. With FHA, you may qualify for a mortgage with a DTI as high as 50%. To be eligible, you'll need to document at least two compensating factors. They include:

  • Cash reserves (typically enough after closing to cover three monthly mortgage payments)
  • New mortgage payment won't exceed current housing expense by the lesser of 5% or $100
  • Significant additional income not used for qualifying(for instance, part-time or seasonal income)
  • Residual income (income left over after paying your bills -- the exact amount required depends on your household size and region)

VA home loan guidelines set the maximum DTI at 41%. But they also allow lenders to calculate residual income and approve loans with higher DTI ratios if residual income is sufficient.

Related: Mortgage With Student Loans

Mortgage with high debt may not be best plan

You might find a lender that will approve you for a mortgage when your debt-to-income ratio is high. But that doesn't mean that adding a monthly mortgage payment to your existing debt load is a smart move.

"If more than 50% of your pre-tax income is going to debt before you pay for groceries, entertainment, transportation and travel expenses, then I would consider paying down your debt before applying for a mortgage to buy a house," says Elysia Stobbe, branch manager with Linthicum, Maryland-based NFM Lending.

If you don't? Stobbe says you'll be house-rich but cash-poor. This means that while you might be able to afford your mortgage payment each month, you won't have enough leftover cash to pay for repairs for your house or furnishings. You might not be able to save for retirement or even afford all your groceries for the month. This could cause you to run up credit card debt as you struggle to pay for daily living expenses.

Related: How Much House Can I Afford? More Than You Think

When a high DTI mortgage makes sense

There are times when it makes sense to take on a mortgage with high debt. For instance, some lenders offer high-DTI loans for graduating medical students, because their income increases substantially once they start work.

If you know you'll be getting a significant sum in the next few months or years, a high debt mortgage could get you into a home faster. And you'll be able to afford it soon enough. This may also be true if you have big expenses going away -- for example, your child will graduate from college and those tuition costs will vanish.

Related: How Should I Prepare to Buy My First Home?

Alternatives to high debt mortgage

But if you have no expectation of increasing income or falling expenses, a costly home could keep you down financially for a long time.

A better option? Stobbe recommends paying down as much of your debt as you can before applying for a mortgage. You should also look for a less expensive house. This will leave you with a smaller monthly mortgage payment, one that won't break your household budget.

Benjamin Ross, a Corpus Christi, Texas-based real estate agent and investor with Mission Real Estate, said that buyers should prepare to buy a home long before they're ready to move. This offers the chance to pay down debts and boost savings, both important factors in qualifying for a mortgage.

"If you are not willing to shed some debt to be pre-qualified by a lender, perhaps now is not the best time for you to make a real estate purchase," Ross said. "It's all about your priorities."

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