Getting a mortgage will probably be the largest transaction of your life — no doubt, it will have an impact on your finances for the next 30 years. With that in mind, when it comes to how much you can borrow for that big transaction, any debts you have now will reduce that amount. And if someone else – a parent, for example – has been paying your debt for you, that party's financial responsibility becomes a critical piece of the mortgage application puzzle.
What Debts Are You Carrying?
Your homebuying power can be affected by any debt tied to, or related to, any of the following:
- credit cards
- any kind of vehicle or recreational loan, including lease payments
- IRS debts
- child support
- student loans
- other housing obligations including insurance, homeowner's association and property taxes
- other mortgage loans
- co-signed loans are also included in this mix
Co-signed debts can be tricky. If you're the co-signer on someone else's debt, it'll be reported on your credit report. Or, even if it doesn't show up on your credit report — if you have a debt obligation, even if another party pays it, it will be counted against you. (To see how debts are affecting your credit, you can see your free credit report summary on Credit.com.)
If you want the debt not to be counted against your borrowing power, you have to demonstrate:
- A history of another party paying the debt
- Why the other party pays the debt
- The other party has a financial responsibility to pay the debt
Proving that another party pays your debt is not a simple task, and the other party needs to be materially responsible for the debt as much as you are. Put simply, they would need to be the co-signers on your credit obligation for the debt to be omitted from calculating your borrowing ability.
Take the following scenario as example: Let's you are trying to buy a home, you carry a $500 per month student loan payment that is your obligation, yours alone. To help out with cash flow, your mom's been making the payment for you — and it can even be documented that she's made the payments. The $500 per month payment would limit your borrowing power to tune of $100,000, which is a big deal indeed in a competitive real estate market, so it's important to make sure you can document the help from Mom.
How to Document the Debt Trail
A mortgage company will ask for specific supporting documentation identifying the fact another party has made the payment directly to the creditor for the past 12 months — or less if the inception of the debt is less than 12 months old. This can be supported with bank statements for the past year showing the payment made to the creditor. Canceled checks made to the creditor or credit card statements showing the payment trail also work.
What Will Not Work
If the other party makes the payment in cash to the creditor, there is no way to document they make the payment, thus your debt (even though someone else pays it) will be counted in your payment-to-income ratio.
If the other party makes the payment from a joint bank account you share – it's the same, it cannot be supported that someone else is paying the obligation.
A word to the wise: Don't pay in cash if you can help it because paper trailing is critically important when applying for a mortgage. Also, it helps to not share the bank account with the person who is paying your debt — if you do, it muddies the water.
What Will Work
Another option is to pay off the obligations in full – which would increase your borrowing power. Better yet if you can do it with your own funds if it doesn't hurt your cash-close or savings requirements with your lender or the loan program to which you are applying.
Gift funds are also another route to pay off the debt. Allowed on nearly every loan option — if it can be documented with a bank statement and a letter, you should be in the clear.
If you can't meet the lending requirements for another party paying your debt and you cannot pay off the debt yourself, it may be time to reevaluate. Work with your lender to see how much mortgage you'd be eligible for (you can estimate how much house you can afford here) with the debt counted into your qualifying figures — or if refinancing, increase the loan amount to cover the debt to reduce the payment-to-income ratio. The payment-to-income ratio is the amount of monthly obligations both in terms of mortgage payment and other debts as a percentage of your monthly income. Generally, lenders want this number to be no more than 45%, in other words, no more than 45% of your monthly income should go to housing and other payment obligations. This is a key measure all mortgage lenders use to determine and support a continual ability to a make mortgage payment.
If you have been turned down by a mortgage company for this reason, do not get discouraged. Get a second, third or even fourth opinion. For all you know, the loan officer with whom you were communicating may not fully understand the lending requirements to meet Fannie Mae & Freddie Mac standards associated with omitting debts. They may just assume tell the potential borrower "no" rather than do the extra legwork that may deal the seal. A sharp loan officer will give you guidance as to what your options are in determining your loan eligibility, loan program and any wiggle room you may have in your finances to successfully close escrow.
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