Credit Card Debt: The #1 Deal Breaker for Mortgage Loans?

Home buyers with a lot of credit card debt may find that a mortgage loan is out of reach, even if they make enough money to afford the payments. Based on our ongoing surveys of mortgage lenders in the United States, we are seeing a rise in the number of borrowers being turned down for having too much credit card debt.

Further evidence of this trend comes from the home buyers themselves. We receive about two-dozen questions every week, mostly from first-time buyers. Many have shared stories about being pre-approved for a mortgage loan, only to see the deal fall through later due to their debt ratios. The frequency of such stories has risen sharply over the last couple of years.

Make no mistake. Mortgage lenders today are very concerned with how much credit card debt a borrower has. In fact, debt levels are one of the top factors that can make or break a person’s chances of getting a loan. Credit scores and down payments are also high on the list.

Credit Card Debt Statistics

How much credit card debt do you have? More importantly, how much of your income does it eat up every month? These are two questions mortgage lenders will want to know right off the bat, before they even send your package to the underwriter.

If you’re like most Americans, you are probably carrying some kind of outstanding balance right now. Here are some disturbing statistics. In 2000, the total amount of outstanding credit card debt in the United States was $680 billion. In 2012, that number is projected to reach $870 billion (source: U.S. Census Bureau, Statistical Abstract of the United States: 2012). That’s about $2,700 for every man, woman and child in the United States. We are truly a nation of debtors, and more so today than ever before.

Credit Card Debt Statistics

The rise in credit card debt can be attributed to the financial crisis of the last four years, at least in part. Millions of Americans had to learn on their credit cards to get through troubled times — job loss, reduced income, foreclosure. This is when the bubble began to swell at an alarming rate. Today, credit card and student loan debt are poised to be contributing factors of the next financial crisis in this country. They will also put mortgage loans out of reach for millions of would-be home buyers.

By itself, credit card debt won’t necessarily hurt your chances of getting a mortgage. More important is the amount of total debt a person is carrying. For instance, if you’re using more than 50% of your take-home pay to cover your combined debts, you may have trouble qualifying for a mortgage loan. Lenders grow more concerned once you exceed the 50% mark, and some set the bar of acceptability even lower. This brings us to another key concept in the mortgage world, the DTI ratio.

How Your Debt Affects You When Applying for a Mortgage

When you apply for a mortgage loan, the lender will look at two key numbers. They’ll want to know (A) how much money you earn each month, and (B) how much you spend to cover your various debts. In this context, I’m talking about the types of debt that show up on your credit reports. This generally includes car loans, student loans, personal loans, and yes … credit card debts.

(Side note: If you’re not sure which debts are showing up on your credit reports, you can find out by obtaining your reports through AnnualCreditReport.com. Learn more)

Back-end debt ratio

Specifically, mortgage lenders want to know how much of your gross (pre-tax) income you are paying toward your debts each month. This is referred to as your debt-to-income ratio, or DTI. These ratios have always been used during the loan approval process. But they are receiving more scrutiny today, as are most aspects of mortgage qualification. If you carry a lot of credit card debt, it could tip the DTI scales too far into the red. This can hurt your chances of qualifying for a mortgage loan.

The Mortgage Lender’s Response: Conditions vs. Denial

If you have too much credit card debt to qualify for a mortgage loan, you’ll find out in one of two ways. The loan officer might tell you up front, when screening your application. Or you might not find out until later on, after you’ve been pre-approved for a loan. In the second scenario, it is the underwriter who raises the red flag. The underwriter is like a financial detective who examines your loan documents to ensure you meet the lender’s guidelines for approval. This process generally comes later, after you’ve been pre-approved for a certain amount.

Regardless of who raises the red flag, there are two possible outcomes:

  • The lender might deny you for the loan.
  • The lender might give a conditional approval that requires certain actions from you.

In the first scenario, you’re simply out of luck and will have to apply through a different lender. In the second scenario, you will have to satisfy certain conditions before receiving the final approval. One of those conditions could pertain to your credit card debt. For instance, the lender might say they can only approve the loan if you pay off a certain card balance (or otherwise reduce your debt-to-income ratio). This happened to one of our writers last year. You can read his story here.

What Borrowers Can Do to Be Proactive

Home buyers should do a certain amount of research before applying for a mortgage loan. Debt ratios should be a key part of that research. You can calculate your DTI by using any number of free calculators online. You have two of these ratios, by the way. The front-end ratio only looks at your housing costs. In the case of home buyers, this would be the monthly mortgage payment that would result from the loan. You also have a back-end ratio that includes your housing costs in addition to all of your other recurring debts (car payment, credit cards, etc.).

Lenders are most concerned with the back-end DTI. If this ratio exceeds 40% with the addition of the home loan, you may have trouble qualifying for the loan. Just bear in mind that DTI guidelines are rarely set in stone, especially when it comes to FHA loans. Allowances can be made for otherwise qualified borrowers.

Some home buyers attempt to pay down their credit card debts, before applying for a mortgage loan. But this is a trade-off that must be weighed carefully. If you use too much of your liquidity to reduce your debts, you might not have enough for the closing costs and down payment associated with your loan. So it may be best to apply for a loan first, before tapping your savings to pay down those debts. You might meet the lender’s guidelines as-is.

Still, you should at least find out where you stand. You should know how much debt you currently have, in relation to your income. This kind of awareness will help prevent any unpleasant surprises down the road.