Just like you don't need perfect credit to land a home loan, you don't need to be debt-free, either. Credit card bills, collections and charge-offs – you can have some or all of these and still make a mortgage work.
Of course, it's never quite that simple. It's often a question of what kind of debt, how much you have and what type of lenders and loan types you're considering.
Lenders can have different requirements and caps for things like debt-to-income ratio and derogatory credit. Here's a closer look at how your bad debts can come into play during the home loan process.
Looking at Your Debt-to-Income Ratio
This is a big metric in the mortgage industry. Lenders may calculate two different ratios, one that looks only at the relationship between your potential housing costs and your gross monthly income and another that considers your total monthly debts and payments. You'll hear these called "front-end" and "back-end" ratios.
Lenders will typically pull in your major monthly debts from your credit reports, including things like student loan payments, car loans and, of course, the new mortgage payment. But they can also include expenses that don't hit your reports, like childcare, child support or alimony.
In December, the average back-end DTI ratio for a conventional purchase loan was 34%, according to Ellie Mae. For VA loans, it was 39%, and for FHA purchases it was 47%.
DTI caps will vary by lender, loan type and more. Generally, conventional borrowers usually encounter a max 50% DTI ratio, while VA and FHA borrowers may be able to push to 65%.
But remember these kinds of figures represent a ceiling – you'd need an incredibly strong loan application (sterling credit, solid assets and more) in order to close with DTI ratios that high. But it is possible.
Dealing With Derogatory Credit
Lenders may also have a cap on the total amount of derogatory credit you have. This is a blanket term that can include things like collection accounts, charge-offs, liens and judgments.
Whether it's $5,000, $20,000 or more, these caps can vary by lender. They may offer exceptions or give additional breathing room for things like medical collections or bad accounts that borrowers are actively trying to repay.
Lenders don't typically factor collections and charge-offs into your DTI ratio calculation unless you're actively making payments on those accounts. In fact, some lenders will essentially ignore a collection if you can show at least a 12-month history of on-time payments.
Charge-offs are debt accounts at least six months past due that creditors have for accounting purposes deemed unlikely to be paid. Some lenders will count charge-offs toward their bad credit cap, while others ignore them.
Much like with DTI ratio, lenders may grant exceptions for derogatory credit if a borrower has solid compensating factors.
Tax liens and judgments will usually need to be paid or otherwise satisfied before a loan can close. Prospective borrowers with a tax lien may still be able to move forward if there's a repayment plan in place and at least 12 months of on-time payments. Lenders will also count those payments toward your DTI ratio.
High debt levels, tax liens and other financial issues are all likely to complicate your homebuying picture. They'll usually mean additional scrutiny from lenders, which often translates into tougher requirements and the need for an otherwise stellar application.
The other consideration is whether it really makes financial sense to stretch your debt burden even further with a home loan. To be sure, DTI ratio doesn't tell the full picture when it comes to mortgage affordability. (You can get an idea of how much house you can afford using this calculator.)
Make sure you're putting yourself on solid financial footing regardless of what a lender's exceptions and guidelines allow. It can help to start pulling your credit reports and credit scores far in advance of when you know you want to buy so you can assess your credit standing, and create a plan to improve it over time. You can get your free annual credit report from each of the major credit reporting agencies. You can also get a free credit report summary, updated monthly, at Credit.com.
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