Decrease Your Debts and DTI Before Applying for a Mortgage

Dream of owning a home but need to borrow money to accomplish this goal? Take a good hard look at your current outstanding debt from credit cards, auto loans, and student loans. If you have a lot of collective red ink, it’s going to be more difficult to qualify for and afford a mortgage loan.

But there are many things you can do to improve your financial situation. Learn more about the value of decreasing your debts, improving your debt-to-income (DTI) ratio, and being a responsible borrower to stand a better chance of mortgage loan eligibility.

In this article (Skip to...)

• Importance of lowering debts
• Understanding DTI
• Lowering DTI before applying
• Best practices for mortgage approval
• The bottom line

America’s debt problem

Americans owe a lot of money to credit card issuers, lenders, banks, and financing companies. Want proof? Consider the following staggering facts:

• Total household debt across the country recently climbed to $17.6 trillion in the second quarter of 2023
• In early 2023, the average credit card balance for Gen Zers was $3,328 versus $6,959 for millennials, $9,589 for Gen Xers, and $8,192 for baby boomers.
• Credit card balances jumped by $45 billion between April and June 2023.

“Americans continue to be married to debt,” says Christopher Roberti, director of strategic growth and mortgage loan originator with Hartford Funding, Ltd. “Over $1 trillion of loans comes from credit card debt as of the second quarter of 2023, the first time in history that consumer credit card debt has topped that mark. Americans have increasingly relied on their credit cards to purchase everyday items. But the latest record increases are being driven by current economic factors including inflation and higher credit card interest rates.”

The importance of lowering your debts before applying for a mortgage

When you are pondering purchasing a home and pursuing a mortgage loan, your financial health will be put under a microscope.

“One of the chief culprits that can impede your mortgage loan approval is outstanding debt,” cautions Andrew Latham, a certified personal finance counselor. “Having excessive debt is a red flag for most lenders, who will perceive you as a high-risk borrower, fearing that you might default on your new loan. But by lowering or, better yet, eliminating your debts, you can increase your credibility and make a stronger case for yourself.”

When buying a home, keep in mind that there are associated costs many people fail to properly consider.

“Lowering your other debt obligations will make a property transaction easier. Having a budget, sticking to it, and paying down your debt obligations is critical,” agrees Roberti.

Understanding DTI

When applying for a mortgage, an important metric that lenders will scrutinize is your debt-to-income (DTI) ratio. This benchmark number is used to determine your ability to manage monthly payments and repay debts.

To calculate a DTI ratio, divide your monthly debt payments by your monthly gross income, then multiply by 100 to get a percentage. For instance, if you earn $5,000 monthly and spend $2,000 on debt repayments, your DTI ratio is 40%.

“Your DTI reflects the proportion of your monthly gross income that goes toward paying off debts, which lenders look closely at,” Latham continues.

According to Felton Ellington, community lending manager for Chase Home Lending, the higher your DTI ratio, the riskier you appear to a bank or lender and the smaller chance you have of getting the green light for a home loan at a good rate. Your DTI also guides lenders on the maximum amount they will permit you to borrow.

“Most mortgage loans require that your DTI be 43% or less,” says Ellington. “For instance, if you make $120,000 per year, which is equivalent to $10,000 per month in gross earnings, you can usually qualify to spend up to $4,300 per month – 43% – for all expenses appearing on your credit report, not just housing.”

The value of lowering your DTI before applying for a mortgage

As with your outstanding debts, it’s smart to lower your DTI ratio prior to applying for mortgage financing.

“A lower DTI signals to lenders that you are a financially responsible borrower. It indicates that you have a good balance between debt and income,” adds Latham.

Let’s say you use credit cards often and carry balances from month to month (meaning you don’t repay what you owe in full each month on your credit card statement). Even worse, assume you were late on a payment or two. These practices will drop your FICO credit score and hurt your chances of qualifying for a mortgage loan at a preferred interest rate.

“Keep in mind that new debt hurts your credit, which may sway a lender to reject your loan application,” cautions Roberti.

Even if you are approved for a mortgage with a higher DTI, you will likely be charged a costlier interest rate, which means you will pay more over the life of the loan.

Best practices for mortgage approval

If some of these negative scenarios apply to you, don’t despair. There are steps you can take to shrink your debt, drop your DTI ratio, enhance your credit, and improve your overall financial situation – making you a better candidate for mortgage loan approval.

Try these tips:

• Carefully review your debts and devise a repayment strategy. “Prioritize paying down higher-interest debts like credit cards. And consider consolidating your debts into a single loan with a lower interest rate, which can simplify your payments and save you money,” suggests Latham, who recommends initiating this step at least a year before you plan to apply for a mortgage.
• Adopt the snowball debt repayment strategy. This confidence-boosting method involves paying off your smallest debts first. Here, you keep paying the smallest amounts required on all of your debts and use any extra money you have left over to pay off the smaller debts while continuing to make minimum payments on the others. As your smaller debts clear, you will have more funds to devote to your bigger debts.
• Alternatively, pursue the avalanche debt repayment strategy. Here, you emphasize paying off debts with the highest interest rates first to save more money on interest.
• Never miss or be late on a debt payment, which can seriously hurt your credit. “Try to place your bills on scheduled autopay to avoid late fees, penalties, and credit score injury,” Roberti says.
• Stay within credit utilization limits. “To maximize your credit score, carry about one-third of what your high credit balance limit is. Case in point: If you have a $1,000 credit limit, aim to carry no more than a $300 balance, and pay that on time every month,” advises Roberti.
• Avoid applying for new credit cards, loans, or lines of credit prior to pursuing a mortgage loan.
• Resist closing any older or existing credit accounts before applying for a mortgage loan.
• Review your three free credit reports carefully, and request from the three credit bureaus (Experian, Equifax, and TransUnion) that any errors or inconsistencies you spot be corrected.

Other steps you can take

There are other measures you can take to further increase your odds of securing a mortgage loan.

“Increase your earnings and consider seeking additional sources of income, like freelancing or part-time jobs. Making more money will help your case as a borrower candidate,” recommends Latham.

Additionally, after you’ve paid off your outstanding debts, save as much as you can and build an emergency fund to prevent accruing more high-interest debt.

“Also, try to save up for a larger down payment – ideally, at least 20%, so that you can avoid being required to pay for mortgage insurance and appear as a more creditworthy candidate to lenders,” personal finance expert Andrew Lokenauth with BeFluentInFinance.com says.

Additionally, maintain a stable employment history.

“Lender’s value consistent income and a solid track record of employment,” adds Latham.

The bottom line

Buying a home requires making sacrifices and getting your financial house in order. Considering this is likely the largest transaction you will make in your life – one that will require assuming more debt than ever before – it’s vital to reduce your existing debts and improve your DTI ratio before applying for a mortgage loan.

“Just be patient as you work on reducing your debt and enhancing your debt-to-income ratio, which takes time. Often, a year of preparation is required before shopping for a loan,” suggests Lokenauth.