Qualifying for a mortgage is a challenge under normal circumstances, but when you layer in divorce on top of the equation, the dynamics can be complicated and daunting.
There’s added risk for lenders, your finances have been dramatically reshuffled, and you’re probably trying to rebuild several parts of your life all at once.
Qualifying is difficult during a divorce. But it’s not impossible.
With help from an experienced broker on your side, and by taking some smart steps, you can increase your chances for approval quite a bit.
Here are 3 roadblocks you may be facing, and 7 strategies that can help:
Roadblock 1: If you have a problem with your debt-to-income ratio…
You may not know if you have a problem with your debt-to-income (DTI) ratio unless you fully understand what it is first. In addition to your credit score, your DTI is one of the primary factors used to determine how solid your financial footing is at the present time.
In simple terms, your DTI compares how much you owe each month to how much you earn. It is expressed in a percentage as a percentage of your gross income (before taxes) that is used to pay certain monthly obligations.
Income can be defined as wages, salaries, tips and bonuses, a pension, Social Security, child support and alimony, any other qualifying sources of income.
When you apply for a loan, a lender will look at your DTI and use certain standards to determine whether or not you can take on an additional payment.
To calculate your DTI, add up your monthly bills, including your rental or mortgage payment, car payments, student debt payments, credit card payments (use the minimum amount due), alimony and child support payments, and other related installment debts.
For the most part, expenses like groceries, gas, utilities, health insurance, and taxes are not included. Double-check with your lender to find out exactly what is and is not considered when calculating your DTI.
Divide this total amount by your gross monthly income. The result will be your DTI, calculated as a percentage.
For example, let’s assume you have a $2,500/mo. rental or mortgage payment, a $500/mo. car payment, a $300/mo. student loan payment, and another $700/mo. in credit card and other related installment debts. For DTI purposes, your monthly debt would be $4,000.
Now, let’s also assume your monthly pre-tax income is $10,000. You would divide $4,000/10,000 to give you a DTI of 40%.
The lower the DTI, the safer you are as a risk to lenders.
This means, if your monthly debt was only $3,000 instead of $4,000, your DTI would instead be 30%.
The next question you probably have is, “what’s considered an acceptable DTI percentage?”
There is no single hard and fast rule. Lender’s standards may vary a bit, but a good rule of thumb is:
- 45% or less DTI – Your debt is at a manageable level. This DTI means you’re most likely going to have enough money left over to take on another obligation.
- 45 to 49% DTI – Chances are you’re managing your debt okay, but in this range, some red flags may pop up for lenders. They may want to see additional documentation that you can adequately take on more debt. Don’t be surprised if you have a tougher time qualifying for a loan.
- 50% or more DTI – As you might guess, your options are probably going to be limited with such a high DTI. Depending on your circumstances, you may not have a lot left each month to save or use toward emergency expenses, placing you in a higher risk category for a loan.
Now that you have a better understanding of what DTI is, let’s take a look at some strategies related to this factor to help you have a better chance of getting a mortgage loan approved during a divorce.
Strategy #1 – Find a co-signer
If your DTI is too high, one way to immediately lower it is to combine your DTI with someone else to come up with a more acceptable overall ratio.
A co-signer will add their name and resources to the mortgage application when a primary borrower does not qualify for a loan on their own. This can tighten up weaknesses in DTI, credit scores, and so forth to make the loan application more appealing for the lender.
Co-signers are common for first-time homebuyers who have not fully financially established themselves yet. Parents often step up in this role.
Older or retired parents can be great co-signers for younger divorcees despite their limited income.
How? Well, did you know…
Lenders will allow new retirement distributions from retirement assets that a retired loan applicant can set up for mortgage qualifying purposes.
Lenders will typically allow someone who has a close family-type relationship with the primary borrower, such as a long-term friend or someone considered similar to that of a family member.
Lenders place this restriction because they do not want a co-signer to be someone with a financial interest in selling the property – such as a builder, real estate agent, or mortgage broker. This presents a financial conflict because these parties would probably realize some kind of gain if your application is approved.
In most cases, the co-signer will sign the loan documents such as the mortgage and deed of trust.
However, they do not need to be on the title or have an ownership interest in the home. Their role can be strictly for loan qualifying purposes.
Becoming a co-signer should not be taken lightly. The financial obligation exists for as long as the mortgage exists. That’s why it’s common for primary buyers to refinance when they’re on better and more stable financial footing. Refinancing on their own (when able) removes the co-signer obligation.
Also, keep in mind that a co-signer arrangement does not work in all cases.
Fannie Mae requires a primary borrower to come up with at least 5% of the down payment from their own funds. And even when a co-signer brings the DTI to a much lower percentage, there are still thresholds that disqualify a borrower no matter how big of a positive influence the co-signer has on the loan application.
Keep in mind – a co-signer will also not be able to help if your FICO score is an issue. More on that later.
The minimum credit score for a conventional mortgage is 620 and an FHA mortgage is 580 (you can go below 580 with a 10% down payment or more).
Strategy #2 – Pay off some debt
More than half of all Americans who have credit cards also have credit card debt.
Carrying a balance is less than ideal but sometimes necessary if you’re dealing with emergencies or unforeseen expenses. It also means you could be racking up a lot of extra costs through price interest rate charges.
When it comes to getting a mortgage loan after a divorce, lenders will look closely at your installment and revolving debts and that could mean the difference between qualifying and not qualifying for a loan.
Balances that are too high or accounts that have delinquencies can torpedo many potential applicants.
Even if you qualify, if you’re deemed a higher potential risk, you may not get the best terms for your mortgage loan interest rate.
That could cost you thousands of dollars over the life of your loan.
For example, if you qualify for a loan at 4.0% instead of 3.5% on a $400,000 mortgage loan, you’ll pay an extra $112 per month. That extra cost adds up quickly.
You could use that extra amount each month to pay off your loan faster and build equity more quickly in your property instead.
Of course, you can always go back and refinance the loan at a later date when your overall credit profile is better. But there’s no guarantee that interest rates are going to be as competitive as they are now.
So, paying off some debt is a strategy that shouldn’t come as too much of a surprise.
The real question is which debt should you pay off so that it will have the greatest impact on your ability to get approved for a mortgage.
You might think that paying off the debt with the largest balance would have the most impact.
In some cases, you would be right. But in some cases, you would also be wrong.
Remember, lenders look at the minimum required payment from your credit report to determine your DTI. That means the most effective way to impact your DTI is to first pay off debt that has the required minimum monthly payment.
If you can plan far enough out, consider getting a new credit card with a low or zero percent introductory rate.
Then, you could transfer high-interest rate card balances over to create a more favorable profile.
Your credit score might be affected short term because of the hard inquiry, but it can be an effective strategy for reducing your required minimum monthly payment.
Many people also pay down debts by getting a personal loan from family or friends.
Using these funds to pay off the right debt can improve your DTI and can spell the difference between getting a loan – or getting denied.
Strategy #3 – Negotiate for additional alimony and child support
When a divorce is handled in a mature and cooperative way, both parties can get more of what they want as they prepare to move to the next chapter in their lives.
If buying a home or refinancing the existing family home is a priority for you, then one of the ways you can better position yourself is to show more income when applying for a mortgage loan.
You may need to give up your interests in other marital assets, perhaps trading away more interest in pensions, giving up tangible property like jewelry, cars, boats or other big-ticket items.
You must remain flexible.
It simply depends on how badly you want to reach your goal of qualifying for a new mortgage, and whether it’s a required piece of your divorce settlement agreement.
Keep in mind that the best way to negotiate for more alimony and child support is to try and work things out directly between you and your spouse.
When you can’t come to an agreement, a judge will make decisions for you, and you may not like the outcome.
Consider mediation, collaborative divorce, or other forms of cooperative negotiations.
When you disclose financial information to your spouse, look for ways to document your case for more alimony and child support.
Factors vary by state, but the courts are often required to consider various elements when determining if a division of assets is fair and appropriate. Learn what those factors are and then think about how you can use them to bolster your claim.
In many cases and in many states, courts are very flexible when it comes to determining alimony levels.
Child support is usually based on a formula used by the state (the Income Shares method is the most common of these).
But even then, courts are given discretionary powers to modify the requested amounts.
Roadblock 2: If you have a problem with a lack of equity…
The Loan-to-Value ratio (LTV) is used by lenders to quantify how much risk they are taking on with a mortgage loan.
It measures the relationship between the loan amount and the market value of the property you want to buy.
For example, if a property is valued at $1 million and an applicant wants to take out a loan for $700,000, the LTV is 70%.
As the LTV increases, the lender faces a larger potential loss if the borrower defaults on the loan. This creates more exposure for the lender.
Lenders are most concerned with LTV at the time the loan is issued. The LTV will change over time as you pay down the principal on the loan and the value of the property either appreciates or depreciates.
Using that same example, if you pay down $100,000 on the loan, bringing it to a balance of $600,000, and during that time the property appreciates to $1.2 million in appraised value, the new LTV is now 50%.
There are cases in a recession where the market value of a property will fall.
When the value of the property is less than the balance owed on the loan, the LTV is greater than 100% and the borrower is considered “underwater” on the loan.
A higher LTV equals more risk, and this may be reflected in a loan’s interest rates.
It is part of an overall practice known as risk-based pricing that also includes looking at a borrower’s credit score, type of property, geographic location (i.e. buying near a major fault line).
To counter this risk, if you’re buying a property with a conventional loan not backed by a federal program, any loan with an LTV of greater than 80% will require that you also purchase private mortgage insurance (PMI).
It varies from about .5% to 1% of the loan balance, and you must carry PMI until your LTV drops to 78% or below.
Some lenders offer “Lender Paid Mortgage Insurance” which is mortgage insurance built into your loan’s rate.
Strategy #4 – Pay down the loan amount
To earn the best interest rates and avoid paying PMI, you want to do what you can to bring your LTV to below 80%.
Lowering your LTV to avoid higher rates and PMI can literally save you thousands of dollars over several years.
You can do this by making a larger down payment, perhaps by negotiating for a lump sum as part of a settlement from one of your marital bank accounts.
The other way to do this is to not buy immediately, begin a disciplined savings program, and make a bigger down payment when you do buy.
Recovering from a divorce is not an all-or-nothing proposition. It’s often done in small steps, and those steps often include buying a home.
Strategy #5 – Use a combination of loans
Did you know you can sidestep some LTV requirements by using a combination of loans?
In some cases, you may be able to achieve up to 95% financing through the execution of a 1st mortgage combined with a 2nd mortgage (or HELOC).
The 2nd mortgage is taken as a home equity line of credit, commonly referred to as a HELOC.
A HELOC is a revolving line of credit secured by your home that you can use for a number of reasons ranging from large expenses, consolidating higher-interest rate debts, or to be used in financing a property.
For example, it may be possible to take an 80% LTV first mortgage loan, and a 15% second mortgage loan to give you 95% financing.
Remember, you may get more favorable loan terms when your LTV is at 80% or below.
Unfortunately, 95%+ financing using this strategy is less common today than in years past because lenders are much less risk-averse.
Instead, it’s more common to see 80/10/10 loans or a variation. This means your first loan is at 80% of the mortgage, your second loan is at 10% of the mortgage, and you supply the final 10% in the form of a down payment.
The second mortgage is often subordinate to the first mortgage and is used frequently to bridge that affordability gap.
In loan parlance, the second mortgage is referred to as a “piggyback loan” because it is taken out at the same time and sits behind the first mortgage.
When second mortgages are closed concurrently with a first mortgage during a property acquisition, they are also referred to as “purchase money second mortgages.”
Sometimes, first mortgage lenders will not handle second mortgages.
Instead, they will direct you to a lender that specializes in second mortgages, as some lenders solely specialize in this type of secondary financing.
It’s important to note that most HELOCs are adjustable-rate mortgages and are tied to a variable prime rate.
The downside to the second mortgage is that the interest rates are variable and usually high relative to 1st mortgage rates.
They are tied to the prime rate which can change whenever the Federal Reserve takes action.
Rates also tend to be higher because these loans are subordinate to a first mortgage, meaning there is more risk for the lender.
If the property is foreclosed on, the 1st mortgage lender is entitled to repayment before the 2nd mortgage lender can collect.
On the other hand, HELOCs can be attractive because you have the flexibility of borrowing over and over again up to your credit limit.
And, in some cases, there is an interest-only payment required during your initial draw period. These benefits can be extremely attractive if you’re just trying to get re-established after a divorce and the goal is to keep your monthly payments as low as possible.
Finally, when using multiple loans, you may be able to stay under conforming loan limits to help avoid jumbo lending requirements. Jumbo loans are typically harder to qualify for than conventional conforming loans.
Roadblock 3: If you have poor credit…
Your credit score, often referred to as your FICO score, can be your best friend or your worst enemy when you’re applying for a mortgage loan after a divorce.
If a low credit score is working against you, there are some things you can do to shore up your score a bit.
Strategy #6 – Take immediate action
Some fixes can have an immediate impact on your FICO score, though not always.
To see where you stand, work with your lender early in the process and pull a credit report to see what may be holding you back.
Alternatively, you can get a free copy of your credit report once a year from Equifax, TransUnion, and Experian at www.annualcreditreport.com.
FICO scores range from 300 to 850 and are made up of the following factors:
- Payment History
- Total Amounts Owed
- Length of Credit History
- New Credit
- Type of Credit in Use
Based on the feedback – you can quickly fix those items that are affecting your score.
Other actions may take more time, but you should implement corrective actions as soon as you can.
To qualify for a conventional mortgage, you’ll need a minimum credit score in the mid-600s depending on the loan program.
And, to get the best loan terms, you’ll need a score of 740 or better to qualify.
To raise your credit score, here are some specific actions you can take:
- Dispute credit errors.
When you pull your credit report, if you spot mistakes (and they are quite common) such as a wrong name or address, wrong account status, or other errors that could lower your score, you can dispute it with the reporting bureau.
Credit bureaus are usually required to investigate the item in question within 30 days unless your dispute is considered frivolous.
- Pay down debt.
Your DTI is critical. Be strategic in what you pay down, but if there is any way to do it, you will increase your score in short order.
The amounts owed (known as your credit utilization ratio) make up 30% of your credit score.
The more of your available credit you borrow against, the more it can negatively affect your score if the balance is large in proportion to the credit limit.
- Ask for credit limit increases.
This will increase your credit utilization ratio.
In many cases, you can get instant approval through your credit card company’s website.
The downside is that a creditor may run a credit check before granting an increase. This produces a hard inquiry on your credit report which could produce a small downward tick in your credit score.
- Open a credit-builder loan.
Diversifying your credit mix helps your FICO score.
These small loans are actually a deposit a lender makes into a locked savings account that you can’t access. Over the next several months, you pay off the loan as you would with any other loan.
After the loan is paid off, the money is returned to you in full.
- Add yourself as an authorized user.
Use a family member’s credit to improve your score by having that person add you as an authorized user on one of their accounts.
When this happens, it is reported on both people’s credit reports. You don’t have to use the card at all. The primary user’s activity is also reported as your activity.
Just be aware that if the primary holder misses a payment or maxes out the card, you’ll suffer the consequences as well.
After you’ve cleaned things up, request a rapid rescore. Making this request can give you updated information within a week or so. It’s much faster than running a brand new credit report since the credit bureaus only aggregate data on a monthly basis.
There are some other things that you DON’T want to do, including:
Don’t close accounts. This reduces your amount of available credit and can cause your credit utilization ratio to jump up.
Don’t miss any payments. Your payment history makes up 35% of your FICO score.
Don’t go on a buying spree. Keep your balances as low as possible for the time being. This applies even if you pay off your balances every month. A good rule of thumb is to keep your balance below 30% of your credit limit. Also, consider paying off card purchases weekly in the midst of a loan process.
Strategy #7 – Apply for a different loan program
If you don’t qualify under the terms of one loan program, consider applying for a different loan.
Mortgage loan requirements vary and minimum FICO scores are not always the same.
Some mortgages are specifically designed to help lower credit applicants get into homes.
Here are several different options that may work for you:
FHA home loans: Although FHA requires a minimum 500 credit score, most lenders won’t go that low. Any score below 580 requires 10% down.
VA home loans: Unlike FHA, the VA does not impose a minimum credit score requirement. However, most lenders will want to see a minimum credit score between 580-620 before approving a VA loan.
USDA home loans: Most lenders will require a 640 FICO score to qualify for a USDA loan, although some will go down to 580.
Conventional loans: Non-government conventional mortgage loans require higher rates and fees for low credit scores.
Home Possible®: Available for low and moderate income borrowers, this program allows for a down payment of just 3%. Most lenders will require a 620 or better credit score.
Fannie Mae HomeReady™: In addition to the low down payment option of just 3%, one of the most appealing traits of the HomeReady program is that it allows non-borrower household member’s income, regardless of their credit scores. Most lenders require a minimum of 620 to qualify.
Non-qualified mortgage (Non-QM): Credit score requirements for non-QM programs can vary, but many lenders offering non-QM loan products will go down to credit scores as low as 500.
If all else fails, there are sub-prime lender options with loose guidelines, but higher rates. You may also consider private money options which have heavy fees, high rates, and are short term in nature).
The bottom line is this….
If you’re facing a challenging mortgage loan situation before, during, or after your divorce – your best bet is to connect with a savvy divorce-focused mortgage professional that can walk you through your options and assess your best personal strategies for getting approved.
Anything is possible!