To understand home debt, you need to know what debt is first. Debt is money that someone owes to someone else. Most people can’t afford to pay for things in full , like a new car or a home, because the prices are much more expensive than your average purchase.
However, you can usually borrow the money from a bank. That borrowed money, which is called a mortgage, then becomes a debt that has to be paid back.
What is good debt?
Good debt is an investment that will grow in value or generate long-term income. Taking out a mortgage to buy a home is considered good debt. It’s an investment and since most home values increase over time, you can actually make money if you decide to sell it. Home mortgages generally have low interest rates and are tax deductible. You may be wondering what that means? Here’s an explanation.
Interest rates
An interest rate is the extra amount charged on a loan. It’s an additional fee which is added to your payment. Essentially, the bank is charging you to borrow money from them. The lower the interest rate, the better. For example, if you borrow $50,000, the bank may charge you 4% interest, and give you thirty years to pay it back. Over time, you would pay US$110,000, even though you only wanted to borrow US$50,000. This is spread out over many years.
Tax deductible
When something is tax deductible, it means you are able to legally subtract it from your taxable income. That’s a good thing!
When you apply tax deductions, you lower the amount of your income that can be taxed. That means you pay less taxes to the Internal Revenue Service (IRS) that year. For example, if you make US$50,000 a year, and you have US$8,000 in mortgage interest, the government will only tax you as if you made US$42,000.
Interested in knowing more about tax deductions? Check out our list!
What is debt-to-income ratio (DTI)?
If you are thinking about buying a home, it’s a good idea to understand debt-to-income ratio (DTI). This will help you understand how much you can afford. Banks calculate your DTI ratio by dividing your monthly debts such as your credit card bills, car payments, or student loans, by how much money you make each year (before you pay taxes).
For example, if you make $50,000/year and have $600/month in bills, your DTI ratio would be 14%. That is excellent! Most banks look for a DTI of 36% or less.
DTI ratios are important when getting a mortgage, but it’s not always enough when it comes to figuring out what you can afford. DTIs do not take into account expenses such as food, health insurance, gas for your car, or entertainment. You’ll want to budget for these things, to make sure you can pay all of your bills each month. Aiming below the 36% target is ideal, especially since DTIs count your income before you pay taxes, not what you actually bring home each month.
Can I lower my DTI?
Yes! The higher your DTI, the more likely you are to struggle with qualifying for a mortgage and making your monthly payments. Here are some ways to lower your debt-to-income ratio.
- Avoid taking on more debt. Don’t shop, take a vacation, or buy something you can’t afford to pay in cash.
- Don’t make any big purchases on credit cards before you buy a home.
- Try to pay off as much of your current debt as possible before you apply for a mortgage.
- If your DTI is too high, it’s best to just wait. Apply for a loan once you get it paid down.
Ask a lot of questions when you sit down with a representative from the bank. You want to know all of the fees and what exactly you will owe each month. You don’t want any surprises when your mortgage payment bill arrives in the mail that first month.
It is a good idea to be careful when taking on debt. Whether it’s good or bad, it’s still debt. If you’re overloaded and can’t pay your bills, it will hurt your financial health and cause you a lot of stress and sleepless nights.