By Credit.com | posted Sep 11th 2013 12:41PM
By Scott Sheldon
Trying to secure a mortgage right now? From higher mortgage rates, to rising home prices to the contraction in buying power — securing financing, for some, can be no easy endeavor. As prices, and rates rise simultaneously, lenders will still place the weighted emphasis on "real income," or, the amount of monthly payment you can afford — as that's what the loan is truly made against. Unfortunately, the amount of debt you have effectively chips away at your "real income." So before you try to get a mortgage, you might want to pay down your debt. Just make sure you do it the right way.
Before I delve into the specifics, here are some quick terms you need to know:
• Debt to income ratio, or DTI: Represents the total amount of monthly debt payment (including the house payment) divided into monthly income. Whenever this number exceeds 45 percent of the gross monthly income, things get tricky.
• Real Income: Also known as "qualifiable income," the net income considered for the housing payment after present liabilities are factored in. If you have $5,000 in monthly income × 0.45, that gives you $2,250 as a total debt allowance. If your other debts total $250 per month, that means your real income is $2,000 per month. Real income is also equivalent to a proposed housing payment.
• Debt: Refers specifically to the minimum payment obligations the consumer is responsible for. This has nothing to do with the total amount of debt, but what the monthly payments are. Lenders are looking for cash flow, how much or how little of it there is. Tip: Debt erodes income (ability to borrow money) at a ratio of 2 to 1; it takes $2 of income to offset $1 of debt.
Now, the strategy for paying off debt to qualify differs when buying a house from refinancing. Let's look at the differences:
Paying Off Debt When Buying a Home: home you can afford
How to Pay Off the Debt and Still Meet the Lending Credit Standard:
Paying Off Debt When Refinancing: you're refinancing
How to Pay Off the Debt and Still Meet the Lending Credit Standard: after the creditor has reported it to the bureaus
If you have debt that otherwise could be eliminated and have the means to pay off the debt, strongly consider doing so, as higher credit risk mortgages tend to be more pricey overall — compared to those for borrowers with lower debt-to-income ratios and better credit scores.
As you get ready to buy a house or refinance your mortgage, it's important to pull your credit reports and credit scores to see where you stand. You can get your credit reports for free once a year from each of the three credit reporting agencies, and you can monitor your credit score using a free tool like Credit.com's Credit Report Card.