Home ownership in Australia is a coveted milestone. But what if you’re already in debt? Is this milestone a far reach for you yet?
While there are a few paths available to you to buy a house when in debt, and each of these need to be explored on their own, we’ll focus on a simple and flexible one here: consolidating debt to buy a house.
Here’s what you need to keep in mind in order to make the best decision possible.
What Is Debt Consolidation?
Consolidating debt is such a practical option because you’re bringing together all your outstanding balances into one account. You’ll also benefit from negotiating a lower interest rate and paying your monthly payment at only one interest rate, rather than multiple high rates.
To consolidate debt, you can opt for options like a balance transfer or work with a creditor or a financial institution to receive a debt consolidation loan. You’ll use the loan to pay your debts and then redirect your monthly instalment payments towards the new, larger loan.
Buying a Home While in Debt
Now that you know how debt consolidation works, let’s turn our attention to your next milestone: buying and owning your own home.
Generally speaking, you have two options open to you for home ownership when you are in debt.
Consolidate debt to reduce overall debt
The first ‘path of least resistance’, as we’ll call it here, is to consolidate your debt before your purchase and spend a few months, or a year, to reduce overall debt.
Why a year? Because your debt is tied into your credit score. The more time you spend making consistent payments and the smaller your balance due, the more your score improves.
Twelve months is usually a good chunk of time to spend making consistent payments on your debt consolidation loan because these payments will tell lenders, who will look at your 12-24 month history of repayments to judge your credit ‘worthiness’ for a new home loan, that you’re willing and able to handle a longer-term financial commitment.
You’ll also have the added benefit of actually reducing your overall debt before you apply for a home loan.
Wait until purchasing and consolidate into the home loan
The second option open to you as an aspiring homeowner with possible debt is to save up a down payment by taking a look at your finances and putting away a certain amount every month until you reach your end goal.
Apply for pre-approval for a home loan, based on an estimated value of the house and see how much you have access to. Next, you’ll want to find a property that matches your financial capabilities for a mortgage.
Once you’re ready to purchase your home, you can work with your lender to bundle your pre-existing debt into the home loan.
This is also a form of debt consolidation — the difference here is that home loan interest rates are typically much lower than consumer credit and, in some cases (depending on your credit rating), lower even than a standard debt consolidation loan.
Improve Your Chances
There are several efforts you can undertake to improve your chances of being approved for a home loan.
Reduce your debt to income ratio
Your debt to income, or DTI, ratio is essentially your total debts and liabilities divided by your pre-tax income. Let’s say, for example, your mortgage repayments for a home loan end up being $2,200 a month. Your DTI would include this amount plus any other debts you have on things such as:
- credit cards or store cards
- personal loans
- other ongoing financial repayments or commitments
- HECS/HELP debt
To reduce your debt-to-income ratio, there are two things you can do (besides paying back that debt):
- If you have unused credit cards lying around that have a high limit but you simply don’t use them, cancel these cards. This will reduce how much credit you actually have available to you, which makes your potential for debt smaller.
- Next, reduce actual expenditure on or use of credit cards or debt instruments to finance or pay your way through everyday life — this means, only pulling out your card when absolutely necessary, not for everyday groceries or entertainment spending.
Know the status of all of your debts
Next, you’ll want to keep an accurate record, for yourself, of all your debts. Where is each amount currently sitting and how much time will it take you to pay everything off?
Note the conditions on each, how much you have left to pay and how much interest you’re currently paying.
Have a good credit record
Maintaining a ‘good’ credit rating is not only about the amount of money you pay each month but also about the consistency of your repayment.
So if you do end up choosing path one — consolidating your debt to reduce overall debt — this is the perfect opportunity to make consistent loan repayments in order to improve your overall credit score.
Make sure you can afford the house you’re considering buying
The loan amount you’re applying for should be one you can actually afford to pay right now, at your current income levels.
Possible Effects of Consolidating Debt to Buy a House
One of the most common questions when considering consolidating debt to buy a house is this: ‘Will this course of action negatively affect my credit score?’
Well, yes and no. The factor here is time.
In the short term, the consolidation of a debt may reflect as a ‘negative’ mark on your credit report. This is because you’re essentially taking out a large loan, which is the sum total of your debts, and paying these small, scattered debts off.
However, over time, as you consistently pay back the monthly repayment on this larger loan, every payment you make is a positive mark on your credit report.
So, in fact, given enough time, it could actually end up reflecting even better and increase your credit rating faster.
As you consider consolidating debt to buy a house, there’s one more thing to keep in mind: Pay attention to the payment schedules of the new loan. This is particularly true if you decide to go with the second option of rolling your debts into your home loan.
Make sure to seek the right financial advice to address this issue. You may end up paying off your credit card debt for the next 30 years — if that’s the term of your mortgage.
The more aware you are of the timing of your loan, how much you’ll save by consolidating when (or before) you buy a house, and what your options are for paying off your loan earlier to save money, the more you are in control of your financial future.