In the second quarter of 2024, the median purchase price of a home in the United States reached $412,300. With prices rising rapidly, understanding what a mortgage is and how it works is more important than ever.
High debt levels can make it more challenging to qualify for a mortgage with a reasonable interest rate, and taking on too much mortgage debt can also make it tough to pay your other bills. Learn more about how mortgage debt can affect your finances for years to come.
What Is a Mortgage?
A mortgage, also known as a home loan, is an agreement between you and a lender. When you take out a mortgage, you agree to make monthly payments until the loan has been paid in full. In exchange, the lender charges interest.
If you don’t follow the agreement, the lender also has the right to take control of your property, sell it and use the proceeds to cover your unpaid loan balance. This process is known as foreclosure. Depending on where you live, your lender may be able to foreclose on your home without filing a lawsuit or getting permission from a judge.
How Debt Affects Your Mortgage Application
When you apply for a mortgage, the lender checks your credit and gathers additional information about your financial situation. For example, applicants typically have to provide tax returns and pay stubs to prove that they earn enough to make their monthly payments. How much debt you have when you apply for a home loan greatly impacts your odds of approval. Here’s how:
- Credit score: The amount of debt you have makes up 30% of your FICO® credit scores. If you have a lot of debt, your credit score may be too low for you to qualify for a home loan. Even if you qualify for a mortgage, you may not get the best interest rate, making it more expensive to borrow money for a home purchase.
- Debt-to-income ratio: Your DTI compares your monthly debt payments to your total monthly income. For instance, if you have $1,000 in monthly debt payments and $3,000 in gross monthly income, you have a DTI of 33.3%. Lenders view a high DTI as a sign that you may not be able to make your monthly mortgage payments. The more debt you have, the higher your DTI is.
If you have a lot of debt, lenders may not be willing to take a chance on you. Even if you qualify for a home loan, the bank may charge you a higher interest rate to account for the risk of lending money to someone with a high debt load. Higher interest rates increase your total cost of borrowing, making homeownership more expensive.
Managing Mortgage Debt Over Time
When you take out a mortgage, your monthly payment includes principal and interest. Principal is the original amount of money borrowed, while interest is the cost of borrowing. The decisions you make during the application process have a big impact on the total amount you pay for your home.
Limiting Your Mortgage Debt
One way to reduce mortgage debt is to choose a shorter loan term. Your term is the amount of time you have to pay back what you borrowed. For example, a mortgage with a 30-year term must be repaid within 30 years. Although 30-year mortgages are common, many lenders offer home loans with 15-year and 20-year terms. Shorter terms usually have lower interest rates, reducing the total amount of money you must repay.
Another strategy for reducing mortgage debt is to wait until you qualify for a lower interest rate. One percent may not seem like much, but it can make a big difference when it comes to how much it costs you to borrow money. Here’s an example:
Assume you want to borrow $300,000 to buy a home. If you qualify for a 5% interest rate, you’ll pay a total of $579,770 over time, assuming you chose a 30-year term. At a 6% interest rate, the same loan will cost you $647,515 over 30 years, a difference of $67,745.
Managing Your Mortgage Debt
Payment history greatly impacts your credit scores, so it’s important to manage your mortgage debt wisely. If possible, set up autopay so that you never miss a monthly payment by mistake. Autopay allows your lender to deduct your payment amount from your bank account, eliminating the need to manually pay every month.
If you want to pay off your debt faster, try making extra principal payments. These payments reduce the amount of principal remaining on your loan, shortening your overall repayment term. Lenders charge interest based on your mortgage balance, so making extra payments may also reduce your total cost of borrowing.
Once you’ve had your loan for a few years, it may be beneficial to refinance, which involves replacing your existing mortgage with a brand-new one. Refinancing is ideal if it gives you an opportunity to get a loan with a lower interest rate, but it is imperative you do a budget analysis and make sure it makes sense for your current financial situation.
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