If you’re looking to buy an additional home, you may be facing a big hurdle: your other debts. The percentage of your income that you pay toward your debt is a critical factor in determining how much house you can afford. If your total monthly debt payments, including your current house payment and your proposed new house payment, exceed a certain percentage, you’ll either need to buy less house or reduce your debt. However, there is an out-of-the-box approach to get you closer to getting the keys.
This percentage is known as the debt-to-income ratio (DTI), and includes the amount of each monthly payment on all debts associated with houses, cars, credit cards, student loans, installment loans, personal loans, government, and marital and child support obligations. All of these obligations, including your proposed house payment, divided into your gross monthly income reveals your payment-to-income ratio — and the maximum lenders want to see is 45% for most loan sizes. If you exceed that magic number, you’ll need to go back to the drawing board.
Let’s say all of your debt payments total $300 per month, and you’re looking to take on a mortgage payment of $2,500 per month. The monthly income you earn pretax is $7,000 per month. Existing debt payments of $300 per month + proposed mortgage payment of $2,500 per month ÷ $7,000 = 40%. A mortgage broker will see this as a very healthy DTI.
Where the Numbers Get Interesting
If you own other properties such as another single-family residence, a condominium or a multi-family property, any and all debt associated with another property would have to be factored into the complete qualifying DTI formula.
If you have one or more indebted properties and are looking to acquire another property, but your DTI is too high, you may have to consider a different tactic. If you want to qualify for a certain price range, the next best alternative (rather than forking over more cash) is to consider refinancing the other home/homes you own. Doing so reduces the minimum payments and improves your borrowing power, thus raising the amount you can qualify for on the new home.
The Golden Ticket to Buying a Home
It’s not uncommon to expect $300 per month in refinance savings, which can translate to as much as $40,000 in purchase price. Let’s take a look at what refinancing can do for your monthly payments.
1. Lengthening the Term
Lengthening the term does improve your borrowing ability because it reduces your minimum monthly mortgage payment. However, it also increases the interest paid over the total life of the loan, resulting in higher interest expenses, unless principal prepayments are made or the property is sold off sooner than the term is up. Since refinancing to qualify is a strategy to make the numbers “pencil” for the upcoming new mortgage, a prudent mortgage consumer would also consider the longer-term plan in keeping that property, renting it for cash flow or possibly selling it in the future to counteract the interest expenses over time.
2. Reducing Rate
As long as you’re going from the same term to the same term, or from a shorter-term to a longer-term, reducing the interest rate is always a viable way to reduce the payment-to-income ratio as the debt associated with the property will be also lower.
3. Removing Private Mortgage Insurance (PMI)
Refinancing to reduce any PMI associated with your monthly mortgage payment will have a strong and dramatic affect on your ability to qualify for a new mortgage, especially if the PMI is several hundred dollars per month or more.
4. Cashing In Equity
This can be accomplished with a second mortgage such as a home equity line of credit or even using the first mortgage to pay off consumer obligations or any other liability hindering your ability to purchase a new home. Since mortgage interest is primarily deductible, this can be a very attractive option for many seeking to improve their cash flow while being able to purchase a bigger and better home.
Before you refinance another property to improve your homebuying chances, ask your mortgage broker how much more borrowing power you’ll gain by taking the plunge. This is a critical first step, as the goal of refinancing is to get closer to the prize. Of course you always improve your loan chances by forking over more cash to increase your down payment, but this approach isn’t always the greenest route due to the reserve requirement (the cash you have in the bank post-closing escrow) that most lenders have for borrowers.
As with any mortgage loan, your complete ability to qualify will be based on your payment-to-income ratio, job history, credit score, credit history, not to mention the amount cash you have available to play with for a down payment, closing costs and those lending reserves.
The better your credit, the better access you’ll have to lower interest rates, which will give you a lower your monthly payment when refinancing and when getting a new mortgage. It’s always a good idea to keep your credit in good shape. That means making a habit of checking your credit reports (you can get them for free every year) and monitoring your credit scores to keep an eye on your progress (and you can monitor your scores for free using Credit.com’s tools). If you notice a large, unexpected drop in your credit scores, that’s a sign to check your credit reports for any issues – a delinquent account, a reporting error or a case of identity theft – and correct them as soon as possible. Then, when you need good credit to tip the balance in your favor, you have it.
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