Consolidating Debt for a Mortgage

When you apply for a mortgage loan to buy a house, you will have to lay most of your financial situation bare for lenders to see. Your total amount of debt may be a concern, as well as your debt-to-income (DTI) ratio. The more debt someone has, and the more of their income they must devote to making payments, the less likely they will be to qualify for a mortgage.

Debt consolidation may help loan applicants whose debt figures are too high to qualify for a mortgage. But be vigilant: attempting to consolidate debt without careful planning may bring complications.

Your debt is only one part of what a mortgage lender looks at as they decide whether to approve your file. In theory, it’s possible that debt consolidation could strengthen your financial profile in the eyes of a mortgage lender and push you over the minimum thresholds to qualify.

» READ MORE: How Much Debt Can I Have When Buying a House?

When should I consider debt consolidation?

According to the Federal Reserve, the total amount of consumer debt in the United States reached $16.9 trillion at the end of 2022. It’s hard to comprehend that number. Think of it this way: The most expensive motion picture ever made as of early 2023, without adjusting for inflation, was 2015’s Star Wars: The Force Awakens. The film had a total budget of $533.2 million. With the total amount of consumer debt in the country, we could make 31,695 movies with the same budget.

We often think of credit card debt as being a major problem, but at $986 billion, it accounts for less than 6% of all consumer debt. The biggest forms of debt are the following:

• Mortgage debt: $11.92 trillion, or 70.5% of the total

• Student debt: $1.6 trillion, or 9.5%

• Auto debt: $1.55 trillion, or 9.2%

Mortgage lenders are concerned about any and all kinds of debt. They primarily look at DTI, which is the ratio of monthly debt payments to monthly income. The higher the DTI, the less money a person will have to pay back the loan. Lenders generally want to see DTI of less than 43%, with lower ratios getting better loan terms.

Debt-to-Income (DTI) Example

Suppose a loan applicant brings home $5,000 per month. Their total monthly payments for student loans, credit cards, and an auto loan total $1,800. Their DTI would be 36%. Assuming they pay for groceries and other living expenses with their credit card, they would have $3,200 left over each month for mortgage payments and related expenses. Their DTI is on the high side, but it is within the acceptable range for most lenders. They could try to consolidate their debt to get a lower monthly payment and, therefore, a better mortgage interest rate.

Another loan applicant has the exact same job with the exact same income, but their monthly debt payments are $2,800 instead of $1,800. This gives them a DTI of 56% and leaves them with only $2,200 each month. Mortgage lenders will consider this borrower to be riskier.

But if the borrower can consolidate their debt to lower their DTI, they may be able to qualify for a mortgage.

How does debt consolidation work?

Debt consolidation is when multiple loans and/or lines of credit are bought by a single lender on your behalf. You are then expected to pay this lender, often at a better interest rate than the total amount you were paying the multiple creditors before the consolidation. This may reduce your monthly payments toward debt.

Let’s begin by assuming that a person who needs to consolidate their debt does not already have a mortgage on a home, or intends to sell their current home as soon as possible.

Personal Loans

You may be able to obtain a personal loan from a bank, credit union, or personal loan company in order to pay off your other debts. Personal loans typically range from $1,000 to $50,000, but some lenders may go as high as $100,000. The APR on a personal loan can be as low as 6%, but it can also go much higher. The goal is to find a rate that is lower than what you are currently paying. Be sure to research lenders carefully before choosing one.

Credit Card Balance Transfers

You may be able to transfer your credit card balances to a new account that offers low or no interest for a promotional period. This period often lasts 12 to 18 months. You might pay a fee for the transfer, but you can use the promotional period to pay down as much of the principal as possible. By the end, you will have a substantially lower balance, which means lower monthly payments and a lower DTI.

Debt Management Programs

A debt management program (DMP) is a way to handle repayment of your debt with the assistance of a nonprofit credit counseling agency. A credit counselor will work with you to find the best options for your situation. You will make a single monthly payment to the agency, which will disburse funds to each creditor. The goal is often to repay the debt within a period of up to five years. Creditors are often willing to accept a lower interest rate and waive fees for debtors who are working with a DMP.

Over time, your monthly payments may decrease to the point that your DTI is low enough to meet mortgage lenders’ criteria. You should proceed with caution, however, as working with a credit counseling agency can lower your credit score.

What are the risks of debt consolidation?

Efforts to consolidate your debt carry certain risks. You need to be careful that you understand the terms of any agreement you make and the effect it could have on your credit.

Credit Score Damage

Every time you apply for a loan or a new credit card, your credit score will take a small hit. Working with a DMP often involves closing existing accounts, which can also lower your credit score. The long-term reward may be worth it, but you should be aware of the short-term damage.

Upfront Fees

Taking on new debt to pay off old debt will almost inevitably cost you money. Be sure that the amount you pay upfront is worth the amount you will save over time.

Over-Leveraging

Aside from simply paying off existing debt, debt consolidation generally involves opening new debt accounts in order to pay off debt or transfer balances. If you do not plan carefully, you can end up increasing your total amount of debt and leaving yourself with few options if you find yourself in need of emergency credit.

Alternatives to Debt Consolidation

In some situations, you might find that you have too much debt for any of these debt consolidation strategies to work, or other factors make them less than ideal. You might still have other options.

Borrow Less Money

You might be able to qualify for a smaller mortgage even if your DTI is higher than you’d like it to be. The question is whether you can qualify for a mortgage that is big enough to afford the home you want.

Get a Co-Owner

With more than one borrower/buyer, you can combine your finances and possibly get a more favorable DTI. This can happen more or less automatically if you are married since, in Texas, you and your spouse co-own almost everything you acquire during the marriage. If you are single, you’d have to convince someone to venture into home ownership with you.

Find a Different Mortgage

You might be able to qualify for a different mortgage program that allows borrowers to have higher DTIs. The FHA mortgage loan program, for example, may accept loan applicants with DTIs of up to 50% in some cases.

File for Chapter 13 Bankruptcy

Filing for bankruptcy is, in essence, a court-guided system of debt consolidation and management. Chapter 13 bankruptcy allows you to create a payment plan in order to substantially pay down most of your debts. You will be able to keep most of your property. At the end of the payment plan period, which typically lasts 3 to 5 years, the court may discharge some of your remaining debts.

Using Chapter 13 bankruptcy to manage your debts has two rather obvious drawbacks. First, you will not be able to take out a mortgage or buy a home during the 3- to 5-year period without the bankruptcy trustee’s permission, and they will be unlikely to give it. Second, bankruptcy will do far greater short-term damage to your credit score than any of the other strategies discussed above.

Take the next step toward homeownership!

The mortgage professionals at The Wood Group of Fairway will give you a clear picture of what it takes to qualify for the best loan option for your needs. While we’re not financial advisors, we are certainly qualified to help you understand what it takes to buy a home. Let us do the heavy lifting for you. You may be surprised by how easy getting a mortgage can be with the right team behind you.

Get started on to see what you qualify for by answering a few easy questions online!