Credit cards play an integral role in your ability to qualify for home financing. If you carry a charge card in your wallet, this particular type of credit card might be the reason why your mortgage chances are a bit rocky. This is what you need to know about charge cards:
Most credit cards have a provision in their credit agreement that allows you to carry a balance and paying interest on that debt over time based on a daily periodic rate. The interest on such cards is typically in excess of 11%. Charge cards operate differently. Charge cards require that you pay off your bill in full every month, requiring you to be more responsible. This is a good thing because they require that you pay off the obligation as part of the card services agreement.
When you are applying for a mortgage, this is when things get interesting if you have a charge card.
Mortgages are made against your income. Debt erodes income for a ratio of 2-to-1. For every one dollar of debt you have translates to two dollars of income that is required to offset the debt. Most people use a credit card for general spending and then pay it off in full each month, others use a credit card for big expenses they can pay down over time or emergencies and have larger month to month balances. If you have a traditional credit card like a Visa or Discover card, for example, and the balance is $1,000 payment, your monthly payment associated with that might be $70 per month. Lenders do not look at what your balance is, they care about what the minimum payment is that you are obligated to pay each month. Yes, it is the payment due at the end of the month, not the total amount owed or how much you choose to pay. This is critical because if you choose to pay more than what is owed, congratulations, you are financially responsible, but the lender is not going to give you any accolades for paying more than what is due.
Let us say that you have an American Express credit card with a service agreement that requires you to pay it off in full every month, akin to a charge card. If your balance on your American Express credit card is $1,000, it will report to the credit bureaus (and subsequently your lender) as though your minimum monthly payment is $1,000. The reason it’s a problem is that the balance and the payment report equal to each other. In this case, the balance is equal to your minimum monthly payment. Having a required payment of $1,000 will blow your debt-to-income ratio sky-high because the lender has to use the full balance of your American Express credit card.
This is where training becomes critical when it comes time to apply for a mortgage. $70 per month on a traditional credit card is a substantially easier figure to account for when the lender is looking at how much payments you currently have in relationship to a new proposed housing payment. The reality of it is that in order to avoid the debt burden on your borrowing power, the American Express credit card would need to be paid off in full by close of escrow. You will have to show the lender a statement showing a zero balance in order to remove the debt from your ratio. Be aware that not every mortgage company will allow you to pay off debt to qualify. Do make sure to check with whomever you’re flying with.
The best thing to do to position yourself in the best place for qualifying for a mortgage, whether buying a home or refinancing one you already own, is to make sure that if you carry a charge card the lender you choose will give you the option to pay that debt off before you close your loan. As a measure of good mortgage planning, if you are going to pay off debts to qualify and improve your ability to borrow on a mortgage, the best way to do that and get the biggest bang for your buck is to pay off the obligations that carry the highest minimum monthly payment with the lowest possible balance. This way you are getting the maximum borrowing power and maximum potential in exchange for a little capital.
If you are looking to get a mortgage, make sure the lender you are working with is a Fannie Mae and Freddie Mac seller and hopefully also a Ginny Mae lender. Correspondent lenders and brokers have limited options in terms of what they can do because their programs have to be underwritten for the masses. Fannie Mae Freddie Mac sellers have the ability to responsibly allow loans that otherwise could not happen to work successfully.
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