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Not all debt is created equal. The type of debt you carry can shape your overall financial picture, including how lenders review your mortgage application. Commonly, debt is divided into two categories: “good” or “bad” debt.
While it may seem like any outstanding balance could hurt your mortgage approval, that’s not always the case. Many borrowers successfully qualify for a loan while managing other payments. A clearer understanding of how debt is evaluated can help you feel more prepared for homeownership.
“Good” debt is generally defined as money borrowing that may support long-term financial goals or earning potential. However, all debt is evaluated, regardless of type. Another key indicator is if you can manage payments responsibly, which can positively affect your credit score.
Some types of debt are commonly viewed as more favorable than others, depending on factors such as payment amount, interest rate, and repayment history.
Student loans finance an education, which can then lead to career opportunities and potentially better income. Student loans can be more favorable than higher interest revolving debt because their interest may be tax-deductible for some borrowers, depending on income, filing status, and IRS eligibility requirements.
Mortgage loans are considered “good” debt because they are used to help purchase a home. As you pay down the loan’s principal as well as live and work on the home, you’ll build equity over time, which may contribute to long-term financial stability. Homeownership may help provide greater stability and the opportunity to build equity over time.
In general, if the debt you take on does not help you generate future wealth or keeps you in a cycle of owing money, it may be considered “bad” debt. This also includes high interest loans that may alleviate the initial pain but ultimately add more debt for the borrower.
Discretionary spending is defined as things you want but don’t necessarily need. This includes things like purchasing a vacation, new clothes, or hobby spending. Taking out debt for items or experiences that aren’t necessities is “bad” debt because it may become difficult to manage, especially if it leads to higher balances or interest costs.
Many people use credit cards because they offer convenience and ease that cash doesn’t have. While they can be a useful financial tool, carrying a balance over time can increase the total cost due to interest.
Some credit cards also have high interest rates or APR, which can make repayment more expensive than the original purchase.
Buy Now, Pay Later (BNPL) loans are an example of debt that can be positive or negative, depending on how you use them. They are a deferred loan, meaning a customer completes a purchase and then pays it back in a series of scheduled installments.
This type of payment plan can be helpful, but installment loans may make it easier for consumers to spend beyond their needs and may affect your credit profile, depending on whether the provider reports payment activity.
When you’re leveraging loan or credit card offers, pay attention to the APR as well as the interest rate. APR, or annual percentage rate, reflects the total yearly cost of borrowing, including interest and certain fees.
Before you take out an additional credit card or a loan, examine the APR carefully. It may be able to save you more money than if you sign up for any loan offered to you.
Experts advise having at least three to six months’ worth of essential living expenses in an emergency fund. According to a recent Bankrate report, only 47% of Americans have access to funds to cover a $1,000 emergency expense. Building your emergency fund can be as easy as putting a portion of your paycheck into a savings account. Then, you can use this money for unplanned costs instead of maxing out your credit card or taking out a loan.
Budget creation doesn’t always mean creating a spreadsheet or saving all of your receipts. Even a bare bones budget that lays out your monthly income versus your reoccurring debt can help you identify how much money you need for necessary expenses.
You may even be able to find ways to save money because you can see how your money is used. From there, you can see if there are certain things you can cut back on, like food delivery or subscriptions you no longer use.
When it’s time for you to apply for home financing, your mortgage lender will look closely at your debt-to-income (DTI) ratio. This metric looks at how much money you owe to others (your debt) and compares it to how much money you earn (your income). Lenders typically look for a balanced debt-to-income ratio, though acceptable ranges may vary depending on the loan program you choose.
Your DTI is one of the factors that show lenders that you may have the financial means to handle the long-term monthly payments associated with your mortgage. Underwriting will also look at your credit report and credit history, which may include specifics about who lent you credit, the account type, limits, and payment history.
If you’re planning for homeownership, understanding how your financial profile is examined can help you take the next steps forward with confidence. While Homestead Funding are not credit repair specialists, we can connect borrowers with a reputable, third-party Fannie Mae approved platform that can work with you to reach your credit goals.
Our Licensed Loan Originators are dedicated to helping our borrowers with their home financing. Explore your options today!
Homestead Funding offers exceptional customer service and a convenient mortgage process. Whatever your financing needs, our goal is to exceed your expectations.
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