How does credit card debt affect a mortgage application?

With debt being so common these days—the average Canadian consumer carried a credit card balance of $3,448 mid-way through the year, according to TransUnion—you might be wondering how, exactly, outstanding credit card debt might affect your mortgage eligibility, and whether it’s something you should be worried about. Here’s what you need to know.

How credit card debt can hurt (or help) a mortgage application

If you have a relatively small credit card balance and diligently make your minimum payments on time, that debt is unlikely to have any effect at all on your mortgage application. But a history of overdue payments or a large credit card balance—especially when combined with other forms of debt—often reduces the amount you can borrow for a home purchase, and it might even disqualify you for a mortgage altogether.

To understand how credit card debt plays into a mortgage assessment, you need to look at two different factors: credit score and debt-to-income ratio.

How credit scores affect mortgage applications

Falling behind on minimum credit card payments or carrying a balance that’s more than 35% of your total credit limit can hurt your credit rating. That’s a problem, because lenders use credit scores to determine overall mortgage eligibility as well as the interest rate you’ll pay. 

Banks usually won’t approve borrowers whose scores are less than 600, while trust companies require a score of 550 or more. (Scores of 660 to 900 fall into the ranges of “good,” “very good” and “excellent.”) Even if lower-score applicants are approved, the rate of interest offered will be extremely high, since the most favourable rates are reserved for applicants with the best credit; their history with borrowing and repayment indicates they are lower-risk. 

Higher interest rates translate into higher mortgage payments, which in turn lowers your mortgage loan affordability.

How debt-to-income ratio affects your mortgage application

When you apply for a home loan, lenders want to make sure you can afford your mortgage payments in addition to all your other housing expenses and debt payments. 

More specifically, the total cost of your mortgage and all other housing expenses (including property taxes, heat, and/or 50% of condo fees, if applicable) should be no greater than 32% of your gross (pre-tax) income, although lenders will occasionally extend that to 39%. This is called your gross debt service ratio (GDS).  

Similarly, the total cost of your mortgage and all other housing expenses, plus all debt service payments (including credit card minimum payments, car payments and student loan payments) should be no greater than 40% of your gross (pre-tax) income, but some lenders may go up to 44%. This is called your total debt service ratio (TDS). 

If your total housing costs and debt service payments are within the 40% TDS guideline, your debt has zero impact on mortgage affordability. If, on the other hand, your TDS is over 40%, you will lose a dollar of housing affordability for every dollar over that threshold that you shell out to service your debts.

What a mortgage affordability calculation looks like in real numbers

Here’s an example to illustrate how credit card debt might affect a couple’s mortgage eligibility, using the GDS and TDS limits at two different interest rates.

If annual household income is $100,000, maximum housing costs (including mortgage payments) should not exceed $32,000 annually ($2,667 a month, amortized over 25 years) according to the 32% GDS guideline. If we assume property taxes, heat and 50% of condo fees total $5,000 a year, that leaves up to $27,000 annually ($2,250 a month) for mortgage carrying costs:

$27,000 mortgage costs + $5,000 other housing expenses = $32,000 total housing costs
GDS = $32,000 total housing costs / $100,000 gross income = 32%

Based on their income, this couple’s mortgage payments cannot exceed $27,000 annually ($2,250 a month, amortized over 25 years), even if they have no other debt. At 5-year fixed rates of 1.75% and 3%, the maximum mortgage loan would be about $545,000 and $475,000, respectively. 

Now let’s look at the couple’s other debts. Say they spend $4,200 annually ($350 a month) in student loan payments, and $3,600 annually ($300 a month) in minimum credit card payments on a $10,000 balance. Their TDS ratio works out to 39.8%:

$27,000 mortgage costs + $5,000 other housing expenses + $7,800 debt service costs = $39,800 total debt load
TDS = $39,800 total debt load / $100,000 gross income = 39.8%

Because their TDS is within the 40% guideline, mortgage borrowing power is not affected. The most the lender will approve in mortgage carrying costs is still $27,000 annually ($2,250 a month), and the mortgage loan qualification amounts above remain the same.

What if, in addition to the above debts, the couple also has a car loan with payments of $6,000 annually ($500 a month)? The TDS ratio now increases to 45.8%, which exceeds the 40% guideline:

$27,000 mortgage costs + $5,000 other housing expenses + $13,800 debt service costs = $45,800 total debt load
TDS = $45,800 total debt load / $100,000 gross income = 45.8%

In this situation, the lender will cut the allowable mortgage carrying costs by $5,800 (to $21,200 from $27,000) to keep within the 40% TDS guideline. In other words, the car loan reduces their mortgage affordability.

$21,200 mortgage costs + $5,000 other housing expenses + $13,800 debt service costs = $40,000 total debt load
TDS = $40,000 total debt load / $100,000 gross income = 40%

With maximum mortgage payments of $21,200 annually ($1,767 a month, amortized over 25 years), the couple would qualify for a maximum mortgage loan of about $430,000 at 1.75%, or $370,000 at a 5-year fixed rate of 3%. In this case, the couple’s debt cost them more than $100,000 in mortgage borrowing power.

Buying a home with credit card debt 

So, what’s the bottom line for you as a home buyer if you carry credit card debt? 

If you have a good credit score but worry that your total debt service is too high, use a mortgage qualifier calculator to identify your TDS value. If it exceeds 40%, you have a choice to make: you can look for a less expensive home, continue saving so you have a larger down payment, or pay down some debt to qualify for a bigger mortgage. If you choose to pay down debt, focus on the one with the highest interest rate—which is often credit card debt—to get the most bang for your buck.

Similarly, if your credit score is less than ideal because you’ve maxed out your credit cards or don’t make your payments on time, your best bet is  to start paying off that debt to improve your score before applying for a mortgage. 

Here are few tips to begin paying off your credit card debt while shopping for a home:

Stop using your credit cards. There’s no sense in continuing to add to your debt while you’re trying to pay it off, so stick to cash or debit until you’ve made a dent in your balance.

Go beyond the minimum. When you make only the minimum payments on your credit cards, very little of that money goes toward reducing your balance—it’s almost all interest. The more you can direct to your payments each month, the faster you’ll get out of debt.

Track your spending. Go through your credit card statements for the last 12 months and see if there are any recurring charges—such as subscriptions or memberships—that you can cancel because you’re not using them. Also log your cash spending (or use an app) to see where else you might be able to cut back and redirect that money to paying off your credit card balances.

Get a lower interest rate. Start by asking your current credit card provider(s) if they’ll lower your rate. If you’ve been a long-time customer and they want to keep your business, they might agree. If not, look around for a card offering a balance transfer promotion with a 0% interest rate. Of course, that promoted rate is for a limited time, so find out how long it lasts and what the rate will be once the promotion is over. Remember: this strategy only works if you use the money you save in interest charges to pay off your balance. 

This article is presented by CIBC Pace It, as part of the MoneySense guide to debt management.