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Consider the use of debt consolidation to qualify for a mortgage very, very carefully. Follow these tips to avoid being one of the 85 percent who fails debt consolidation.
- Debt consolidation can lower your debt payments, allowing you to qualify for a larger mortgage
- Debt consolidation can be a home equity loan, debt management plan, or unsecured financings like personal loans or balance transfer credit cards
- Consolidating your debts can extend your repayment and increase your costs
Debt consolidation works for a small percentage (about 15 percent) of those who try it. Be careful out there.
If it weren’t for all that debt...
If you’ve ever wondered how to consolidate debt to qualify for a mortgage, you’re not alone. We owe $1.38 trillion in student loans, $830 million in credit card debt, $1.22 trillion in auto loans, and a mere $390 billion in “other” debt.
If you have avoided these debts, if you owe nothing to anyone, mortgage lenders will greet you with fragrant blooms and festive meals.
However, for the rest of us, getting a mortgage may not be so easy.
Lenders are very concerned about debt. Typical guidelines say that as much as 43 percent of your gross (before tax) income can be used to repay monthly debts like your housing, credit card and auto payments.
Dividing these bills by your monthly income determines your debt-to-income ratio or DTI. If you have a household income of $7,000 a month, 43 percent equals $3,010. That’s your limit for housing plus other account payments. (But not living expenses like food and utilities.)
If you have two car loans at $500 each, $400 a month in student debt, and $200 for credit cards, that’s $1,600 a month, leaving just $1,410 a month for mortgage principal, mortgage interest, property taxes, and property insurance.
In a lot of markets, that leaves less than $1,000 a month for the mortgage itself. At 4.5 percent over 30 years, a borrower qualifies for about $200,000 in financing.
How debt consolidation works
If you already own a home, a home equity loan for debt consolidation is probably the cheapest form of financing available. But you’re trying to get a home, so home equity is probably not an option for you.
If your monthly payments are too high to qualify you for the mortgage you want, you may be able to stretch those ratios by lowering your payments.
For instance, suppose you owe balances in three credit cards with an average interest rate of 14 percent, and you can pay them off with a five-year installment loan at 6 percent, why wouldn’t you? You will pay less each month, and your debt will be gone in five years. Unlikely if you keep making the minimum payments you currently have.
- Account A payment: $63
- Account B payment: $95
- Account C payment: $127
- Total: $285/mo
- New Personal Loan: $174/mo
That extra $111 a month could help you qualify for a bigger loan. At 4.5 percent, with $7,000 a month income and $285 a month in expenses, you can borrow $437,000. Drop the debt to $174 and the loan increases to $460,000.
Get approved for a personal loan
The above scenario can be achieved with a personal loan. Personal loan companies are fine with you using funds for debt consolidation. And it will put you in a better position to buy or refinance a home.
Loan amounts are typically $35,000 to $50,000, but some lenders will approve loans up to $100,000.
Zero-balance credit cards and balance transfer deals
One method for disciplined debtors to consolidate is to transfer the whole mess to an interest-free account and pay that thing down as fast as possible. There may be a charge (3 percent upfront is typical) but if you use the 12 to 18 months many of these cards give you to clear your debt, you can save a lot of interest.
That $9,000 debt in the example above? At a 14 percent rate (typical credit card interest), you could save over $1,000 by paying it off in 18 months at zero percent than paying it at 14 percent.
Don’t do this if you cannot take your newly-zeroed accounts and leave them that way. That’s the number one reason debt consolidation fails — borrowers run their accounts right back up again.
Debt Management Programs (DMPs)
For those who really have a hard time managing debt, credit counseling from a reputable non-profit agency can turn finances around. In addition to budgeting advice, and sometimes intervention with your current creditors, counselors also offer DMPs.
Debt management plans require you to make a single payment to the agency or counselor once a month. The plan distributes this money to your creditors. Many creditors will reduce penalty interest rates or late charges if you enroll in such a plan. However, research carefully.
Debt management is not the same as “credit repair” or “debt settlement,” which are both pretty sketchy strategies some use to try and escape their debt. And don’t go with an untried company — one that might take your money and not pay your creditors.
Alternatives to debt consolidation
So the question is, what can you do if you have a lot of debt?
Chapter 13 Bankruptcy
Yes, technically, Chapter 13 bankruptcy is a debt management plan. It’s court-ordered, though, so your creditors don’t get to decide if they want to offer it to you or not. Many experts consider bankruptcy a last resort, and it definitely won’t help you buy a home because your credit will take a hit.
However, if a DMP can’t get you out from under your debt in five years or fewer, some personal finance and legal experts recommend it.
One strategy is to find a mortgage program which has a higher DTI limit. There are some programs out there (including FHA in some circumstances) that allow a 50 percent DTI. However, look twice to see if you really can afford the loan.
- Will your new housing costs rise significantly?
- Do you have emergency savings to make a payment or two if your income is interrupted?
- Do you manage your debt well — never carrying balances on cards and paying every bill on time?
Some people only have one bill — their mortgage — and can buy more house because they avoid excess spending.
Another choice is to borrow less. This may be very plausible outside major metro areas. Or buy with a friend or relative.
While there may be ways around it, the real problem for too many cases is owing too much. Many of us need to have less debt not only because it’s financially prudent, but because it’s simply comfortable. We like to sleep better at night.
Heads up: You still owe the money
It’s great to pay down debt. Your credit score will improve, and that will help with a mortgage application. However, moving debt from a credit card to a home equity or personal loan doesn’t magically make it go away. You only get debt-free by actually paying off the alternative source of funds.
And paying down old debt doesn’t do much good if you create new debt. You have to deal with the whole debt cycle and that means you have to have a budget.
How to consolidate debt to qualify for a mortgage means having a budget. I know, ugh. But the reality is that we all must live within our means. If we don’t do this, we don’t get mortgages. And we can’t freely leave our jobs. That’s the real cost of big debts.