Your debt plays a major role in determining whether you qualify for a mortgage or not. This is because lenders utilize your debt-to-income ratio to assess your ability to repay and determine how much you can borrow.
What Is Debt-To-Income Ratio?
Debt-to-income is a finance figure that compares your total debts to your gross income. Lending institutions calculate your debt-to-income by dividing your monthly debt commitments by your gross income. Generally, most lenders prefer a debt-to-income of 36% or less.
Before taking on any debt, it's important to ascertain whether it will help meet your financial objectives or worsen them. For instance, the type of debt you take on can mean the difference between getting your mortgage approved or denied.
To help you make an informed decision, here are common types of debt you should know.
Four Types of Debt
1. Secured Debt
Any debt that utilizes some form of collateral is considered a secured debt. Although lenders run a credit check before offering the loan, they will also need an asset to be used as collateral.
For example, when buying a car on credit, the lender offers the cash but places a claim of ownership on the vehicle. If you don't repay, the lender can repossess the car and sell it to get their money.
In most cases, secured loans have reasonable interest rates. However, it can vary widely depending on the value of the asset used as collateral and your credit score.
2. Unsecured Debts
Unlike secured debts, unsecured debts don't require any form of collateral. The lender offers the loan based on your promise to repay and your financial ability. But, you must sign an agreement so that they can sue you to recover their money in case you default.
Unsecured debts usually have high-interest rates. Common examples include signature loans, medical bills, and credit cards.
3. Revolving Debt
Revolving debt is a type of loan where a consumer pays a commitment fee to a lending institution to borrow money when needed. This allows the customer to borrow up to a certain amount on a regular basis.
This debt is suitable for entities or people that experience unexpected expenses or cash flow fluctuations. Though these debts offer convenience and flexibility, they usually attract a higher interest rate than conventional installment loans. Examples of revolving debt include home equity and personal lines of credit.
A mortgage is a loan taken by a consumer to buy a home. The property, therefore, serves as collateral. Most consumers have mortgage loans because they have low-interest rates and usually offered for a long time like 15 to 30 years.
As mentioned earlier, most lenders use your debt-to-income ratio to decide whether to offer the mortgage or deny. Lenders also use the ratio to determine how much you can borrow.
Since most consumers have some form of debt, the decision will also depend on whether you have good or bad debts.
Good Debts vs Bad Debts
Debt is good if it increases your net worth or generates more income. Bad debt, on the other hand, is any loan taken to buy depreciating assets. These are assets that neither generate income nor increase in value.
Example of Good Debt:
- Student loan: Allows you to improve or get an education and boost your future earning's potential.
- Mortgage: Gives you somewhere to live, converts living expenses into an asset and provides security and stability.
- Small business loan: Debts taken to start or grow a profitable business to increase your cash flow.
Examples of Bad Debt:
- Payday loans: Small-dollar loans with significant fees and extremely high-interest rates.
- Credit card loans: The interest rates are usually high and repayment schedules designed to maximize costs.
- Car loans: Paying high interest on a vehicle can be bad because cars depreciate.
Your debt-to-income ratio has a huge impact on your mortgage. Consumers with the lowest debt-to-income ratio often get the best mortgages, repay the loan and live comfortably.
To lower your debt-to-income ratio before applying for a mortgage:
- Don't take on more debt
- Avoid making big purchases on credit
- Strive to repay your current debt as much as possible
Want to learn more? Reach out to a local loan expert for assistance.