Editorial Policy

Heavy debt squashes mortgage hopes

Eva Norlyk Smith Ph.D.

November 4, 2013

QHi Eva,

My husband and I are planning on buying a house in the next year, but there a few things that we need to work on, regarding his credit. We have three credit cards that were closed and still have a total balance of $5,300 (total) on them as well as three open cards (also with balances). The person we are working with to qualify for the mortgage explained that we need to get the balances down to 20 percent of what we owe to get the score up. How does this apply to the cards that are closed? The cards were closed by the card grantor because we got behind a few months back, but we are now up to date.  — Heather

AHi Heather,

Well, kudos to you and your husband for setting such a great goal for yourself. Being a homeowner brings many financial benefits, and it's just a wonderful thing to own your own home.

Buying a house often involves months, if not years, of planning, and often significant changes around one's financial priorities. In your case, in addition to saving up for a down payment, you have a few more obstacles to tackle before you can qualify for a mortgage. Here's how to proceed.Ask Eva

1. Get your credit card balances below 20 percent. The person you're working with is correct — you do need to get your credit card balances down to 20 percent of the card credit limit. And yes, that applies to the cards that are closed as well.

The reason this is important relates to a major component of credit scores known as credit utilization, or the debt-to-limit ratio. This factor accounts for a full 30 percent of credit scores, and to get the highest rating on this component, the balances on your credit cards should be below 30 percent — ideally lower when you're talking about a major loan, such as a mortgage.

So what's the current credit utilization on your credit cards? Well, you kindly sent us the information on the cards that are open, so let's do the calculation here. For the open cards, you owe a total of about $2,200 across three cards, which have a total combined limit of $2,600.

To calculate the credit utilization percentage, divide 2,200 by 2,600 and multiply by 100, and you get a 84.62 percent credit utilization. Ouch. To get down to 20 percent utilization, you'll need to reduce balances to 20 percent of $2,600, which is $520. This means that across all the three open credit cards, the combined total balance should never go above $520, at least when you're applying for a major loan.

The three closed cards are not helping you either. Because the cards are closed, their limits aren't counting toward your credit utilization numbers. Yet the fact that you got behind on payments (to the point where the issuer had to shut down the cards) will continue to pull down your husband's credit score. Plus, $5,300 is a large amount — enough to make a lender doubt whether you can keep up with mortgage payments and debt payments. So I'd apply the 20 percent rule here — get those balances down to 20 percent of what you owe. Better yet, zero them out completely. As long as you continue to make payments on those cards, your husband's score will eventually bounce back, but it will take time.

2. Tackle your credit card debt. There's a bigger issue at play here. With balances that high, you end up paying a lot of money in interest charges.

Worse, because you missed payments on the three cards that got closed, they have now likely gone into a default penalty rate, which for most cards is a whopping 29.99 percent. To find out what your interest rate is, simply check your credit card statement.

This is a problem because it makes it very hard to get out of debt. With a penalty interest at about 30 percent, for every $1,000 you pay each year to get rid of your credit card debt, more than $300 goes to interest payments (it ends up being more than $300 because you also pay interest on the cumulative interest charges).

Your best option to get rid of your debt faster is to find a good credit counseling agency to work with. These are nonprofit organizations, and they can do several things for you and your husband.

First, they can help you create a plan both for paying down your debt and for taking additional steps to improve your credit score. Second, they may be able to put together a debt management plan for you. These are plans that take into account your income and debt and come up with the best and most realistic payment strategy. Most significantly, according to Sandy Shore, a spokeswoman for the credit counseling agency Novadebt, most credit counseling agencies can negotiate rate decreases with card issuers. That means they will likely be able to get those interest rates lowered, so you can knock out the debt faster.

To find a credit counseling agency in your area, look for one that is affiliated with the Association of Independent Consumer Credit Counseling Agencies (AICCCA) or the National Foundation for Credit Counseling (NFCC). The NFCC also enables you to start your credit counseling session online, if you prefer.

3. Take a closer look at your spending. Last but not least, look at your spending habits and figure out why you have run up such high credit card debt. Are open credit lines too tempting? Or are your monthly financial obligations so high that you run short on funds each month?

In either case, your spending will affect your ability not just to qualify for a mortgage, but also to hold on to the house once you have it. If you fall behind on credit card payments, your credit scores get damaged; but if you fall behind on mortgage payments, you stand to lose the house you worked so hard to buy.

So before venturing into a house purchase, you want to make sure that you are able to match your spending to your income, so you don't have to face the considerable stress of potentially defaulting on a mortgage down the road.

Buying a house usually means making sacrifices financially. But as you learn to balance income and spending and eventually settle into your own little nest, you will find that the journey has been well worth it.

Got a question for Eva? Send her an email.