The Role of Debt in the Mortgage Process

Your goal throughout the mortgage process is to demonstrate that you can afford a mortgage. So when borrowers apply for a mortgage, and there’s a section on the application that asks them to list their debt, many borrowers get concerned: just exactly what do lenders mean by “debt”?

According to Merriam-Webster’s online dictionary, “debt” is an amount of money that you owe to a person, bank, company, etc. Lenders look at it to assess your credit worthiness, using debt-to-income ratios to ensure you can handle monthly payments and repay your debts.

Debt falls into two categories: installment debt and revolving debt.

Installment debt includes items such as car loans, where the payment and interest rate are fixed for the entire term of the loan, and you know exactly when that loan will be paid off. Car loans, and other types of installment debt with ten months or less to pay off, must be listed but don’t need to be included in your debt ratios.

Revolving debt includes credit cards and other lines of credit. The payment amount and interest rate may fluctuate monthly, and there is no set date as to when it will be paid off.

Other monthly expenses such as gas, food, and clothing aren’t included in debt calculations for most mortgages. Lenders take these expenses into account but don’t verify them.

One exception is Veteran’s Administration loans, which you may want to investigate if you’re eligible. This is one situation where you will be asked to provide a list of these other expenses. The VA loan program uses them in what is called a “residual income calculation.”

In most cases, the less debt you have, the better. However, this doesn’t mean that you shouldn’t have any debt at all. Having some credit available is beneficial, especially if it’s paid in full, monthly.

Your mortgage professional can tell you more.

The Equity in Your Home Can Be Your Very Best Friend

Equity is the difference between what you owe on your home and what it’s worth. For example, if you buy a home for $100,000 and obtain an $80,000 mortgage, your equity is the difference, which is $20,000, or 20%. Equity in your home will change as the value and your outstanding mortgage balance change.

As equity grows over time, you can use it in different ways. For example:

If you want to sell it and buy another home. You can take the equity in your existing property and use that as a down payment on a new property. Investors often use this technique because they use less of their own money.

Tap into your home equity by taking a loan or a line of credit against it. For example, if your home’s value is $100,000, and your mortgage balance is $70,000, your equity will be $30,000. You can borrow, say, half of that from a bank to use for any purpose (such as renovations or to purchase a new home).

In this example, you can also take a second mortgage for up to $15,000. But if you already have a mortgage on your home, it may be more challenging to arrange than the first. And interest rates will be higher.

Second mortgages are riskier, so lenders charge higher interest rates. The reason: If you default on either the first or second mortgage and the property is sold, the first mortgage holder will be paid back first. The second lender takes second place.