Good Debt Vs Bad Debt - How does debt affect your chance of getting a home loan?

Good Debt Vs Bad Debt - How does debt affect your chance of getting a home loan?

You found the house of your dreams and are intent on buying it. But you’re worried about your current debts and how they could impact your ability to get a home loan.

Not all debts are bad; in fact, some of them can positively impact your mortgage eligibility. In this article, we will try to understand the difference between good debt and bad debt. 

How debts impact your chance of getting a home loan

Your debt-to-income ratio (DTI) is the result of dividing your total debts and liabilities by your gross income (before tax income). The bigger your DTI is, the lesser your chance is at getting a mortgage. It basically determines your borrowing power. 

Lenders do look at your debts and weigh those in when assessing your ability to repay your mortgage. They generally classify these debts as either good or bad.

Good debt

A debt is considered good if it is the kind that allows you to make more money, build wealth, or purchase something that will grow in value or augment your income in the future. 

Types of good debt include:

Existing mortgage

The fact that you have a current mortgage lets lenders and banks know that you own your property and you can tap into its equity to produce a bigger deposit for your second property. 

Credit card (when used responsibly)

Credit cards help build your credit score. When you are making your payments regularly and on time, your credit rating improves. This usually gives lenders proof that you are a reliable, low-risk borrower. 

Investment/business loan

This type of loan involves using money to make more money. Most Australians build their wealth this way as it helps businesses expand and grow. 

Bad debt

A debt is considered bad when it is spent on things that diminish in value over time or the moment you buy them, e.g., entertainment, food, clothes, hobbies, lifestyle, and other consumables.

Types of bad debt include:

Personal loans

Personal loans can easily lower your borrowing capacity as it decreases the amount of income you have to pay off a home loan. They also usually have higher interest rates.

Credit cards (when used irresponsibly)

Conversely, a poor credit score from being delinquent or tardy with your payments will adversely impact your loan eligibility. You will get a poor credit score from having defaulted a loan, unpaid utility bills, or payments that are made 14 days past their due date.

Car loans

Cars depreciate in value the moment you drive them out of the dealership, and the value continues to go down from there. This makes them not a very great asset to be paying interest on. Car loans also have high-interest rates.

Buy now, pay later accounts

Consumer debts from having “buy now, pay later” accounts are bad because they make it easier for you to spend big. Note that your spending decisions (do you really need those shoes now?) could severely affect your borrowing capacity especially when lenders would reviewyour expenses against your income.

Mobile phone contracts

Your credit rating is impacted by your mobile phone contracts. Unpaid phone bills, a single late payment from years back or a contract you’ve forgotten can catch you out on your mortgage application.

What you can do to improve your borrowing capacity

It is best you curb your spending habits and reduce your debts or pay them off altogether when preparing for your home loan application. The lesser debts you have, good or bad, the better.

Better yet, talk to a trusted financial specialist to discuss how you can manage your debts and get you ready to take the next step toward buying. 

We’re happy to help. Schedule a call with us today on 0421934033.