Not all consumer debt is bad. While nuances exist, most experts agree that some consumer debt is 'good.' Knowing more about debt when you're looking to purchase your first home or a new construction home is wise. Hopefully, this article will help teach you about debt and get you a few steps closer to a mortgage approval letter.
You may be tempted to pay off all your consumer debt before buying a new home, especially if it's move-in-ready and fully loaded. We wouldn't blame you if you did. That said, responsibly managing 'good debt' while ridding yourself of 'bad debt' can increase your wealth over time. A little bad debt won't destroy your mortgage approval odds.
Bankruptcy Law defines consumer debt in Title 11 U.S.C. § 101 as "debt incurred by an individual…for a personal, family, or household purpose". Federal law and most states primarily consider any other debt as non-consumer debt or business debt. Lenders do not consider all consumer debt 'bad' though. Equally, they don't assume all consumer debt is 'good.'
Mortgage lenders generally look at all good and bad debt, with exceptions to certain obligations when applying for a government-backed loan.
Lenders need to know your net worth and debt-to-income ratio before approving your loan for a new house. Homebuilders do too. Both have resources that help you with questions, tell you about their lending and homebuying process, and help set your expectations.
For example, some states regard student loan debt as non-consumer business debt or 'good debt.' Lenders will still count this debt when determining your net worth and D.T.I. ratio.
Likewise, lenders may consider medical debt in their decisions on privately backed mortgage loans, even though the government categorizes medical debt as 'non-consumer debt.'
Government-backed loans, such as F.H.A. loans, are prohibited from counting medical debt towards overall debt when determining D.T.I. ratios. They can include it when determining your net worth, however.
To keep your debt manageable and maximize your mortgage approval odds, ensure your overall debt does not exceed 36% of your pre-tax income. In short, for better approval odds, keep your monthly debt below 36% of the amount of money you make.
Debt can be good if you are going in the hole a little bit now for financial gains at a future date. These gains should cover the principal and interest of the debt and a profit or tax advantage. That's why some consider student loans as good debt. You invested in education to further your career and earning potential.
As a rule of thumb, if you can include the debt on your tax returns, you are dealing with good debt. Examples include:
Too much of a good thing can still be harmful, so ensure your good debt is manageable while eliminating and avoiding bad debt. Lenders won't care if your D.T.I. is 50% and all 'good debt.' They don't know when you will make more from your new business plan or the degree you are working to earn. Good debt is still a monthly bill. If you want to purchase a home, keep all debt below that magic number 36.
Mortgage companies do look at net worth, among other considerations. Net worth tells lenders how much money you have. Bad consumer debt decreases your net worth, usually immediately and semi-permanently. Your net worth drops until you make the difference with more income than you spent on lousy consumer debt.
As a rule of thumb, if your purchase decreases in value, it's bad debt. Moreover, suppose you cannot write your debt off or it doesn't improve your tax return. In that case, it's bad debt.
Bad debt decreases in value over time and provides no tax benefit.
Use an online financial calculator tool to discover how much your net worth decreases with bad debt. Examples include:
A Word on Debt Consolidation Loans
If you are struggling with finances, taking out a home-equity line of credit (HELOC) is probably not a good idea for debt consolidation. Debt consolidation loans are suitable for bringing down your monthly payment. Still, the interest most people pay over the life of the loan is often more than what they would have paid had they paid each bill separately. You could risk losing your home if you are already struggling with finances.
If you need to build credit or restore your credit rating, taking out a new store card or credit card may be inevitable. You can avoid accumulating lousy debt by carrying a small balance on your cards and paying them off in full each month. Always pay cash for things like cars, furniture, and vacations. A get-around beater car to which you own the title is much more relaxing to drive than a convertible Mercedes with burdensome payments.
Suppose you already have plenty of bad debt and not enough good debt. In that case, you may need to resolve some of this bad debt before you can start building the good kind that will increase your net worth and improve your chances of being approved for a mortgage. The steps below outline one way to accomplish this:
When considering going into debt for something, consider whether your purchasing will increase in value and your overall net worth over time. If it will, this is 'good' debt. If the item decreases in value or your overall net worth over time, it is 'bad' debt.
While mortgage lenders will look at both good and bad debt, incurring a little bit of 'good' debt and resolving and avoiding 'bad' debt will help you secure a mortgage. Living by the good debt vs. bad debt principles is an excellent way to improve your financial position and increase your mortgage approval odds.