- Should I Save for a Down Payment on a House or Pay Off Debt?
- The Application Process
- Case Study
- How the Loan Amount Is Determined
- Additional Considerations
- Final Word
- Should I pay off debt before buying a house?
- Should you be debt-free before buying a house?
- 1. Should I take a mortgage out with existing credit card debt?
- 2. Pay off debt first
- 3. Considerations before buying a house when they already carry debt
- 4. How to pay off credit card debt quickly
- 5. How it impacts couples with credit card debt who want to buy a house
- Should You Pay Down Debt Before Applying For a Mortgage?
- Debt to Income Ratio
- Debt and Credit Scores
- Cash on Hand for the Buying Process
- The Bottom Line
- Should I Pay Off Debt Before Buying a House?
- Bottom, line: Pay off your debts first.
- Laura Adams, author, and host of Money Girl podcast responds…
- A mortgage is considered “good debt”
- The tax benefits of mortgages
- Another financial goal you may have missed
- Pay Off Credit Card Debt Before Applying For A Mortgage
- You don’t need excellent credit, but it helps
- What about debt-to-income ratio?
- Additional information
- Bottom line
Should I Save for a Down Payment on a House or Pay Off Debt?
When you’re preparing to buy a home, it’s important to get your finances in order. Not only will you have to be organized to fill out the loan application, but you want to otherwise streamline your finances to improve your chances of being approved for a loan and qualifying for a lower interest rate and a larger mortgage amount.
In fact, how much you have for a down payment is pivotal to this determination as is an assessment of your existing debt. But this creates a conundrum. If you have both a healthy down payment and a fair bit of debt already, what do you do? Do you pay off the debt and put up a smaller down payment, or do you keep both the debt and down payment intact?
The answer to that question isn’t difficult, but requires a close examination of your personal situation, such as how much of a down payment you can afford, how much debt you have, what interest rate it’s at, and how big of a mortgage you want to qualify for.
The Application Process
When you apply for a mortgage, the bank or broker will take into consideration the income you receive on a regular basis, as well as the debt payments you currently have. This will give them a picture of how much money you can spare each month to put toward a mortgage payment.
this, your other assets, your credit history, and your down payment, the bank or broker will determine how large of a mortgage they can offer you and at what rate.
Consider Jim, who is preparing to buy his first house. He has very good credit and takes home $36,000 per year after taxes.
Jim also has credit card debt of $10,000, which has a minimum payment of $250 per month, but has no other debt. Jim saved up $20,000 to put towards his down payment and is looking for a 30-year fixed-rate mortgage.
We’ll assume that home insurance costs $800 per year and property taxes are $2,000.
If Jim uses $10,000 of his down payment to pay off debt instead, he will qualify for a different mortgage amount than if he pays off no debt and puts the entire $20,000 down.
Assuming Jim is able to qualify for a 6% interest rate, here’s how the numbers work out.
Also, the consideration of private mortgage insurance, or PMI, does not significantly affect this comparison and is excluded for the sake of simplicity.
$20,000 down payment, $250 per month in credit card debt
- Monthly payment (including mortgage, taxes, and insurance): $830
- Total price of house: $119,519
$10,000 down payment, no debt
- Monthly payment (including mortgage, taxes, and insurance): $1,073
- Total price of house: $150,105
That’s a pretty big difference! Jim can qualify for a mortgage that’s $30,000 larger if he pays off his debt, even though his down payment is half the size. Why is the difference so large?
How the Loan Amount Is Determined
It has to do with how the bank calculates what you can afford to pay. Generally, the bank will take a percentage of your total monthly income (36% is common) and assume that is how much you can pay toward all your debt, including your mortgage.
In other words, your existing debt payments will directly reduce the amount the bank thinks you can pay towards your mortgage payment, homeowners insurance, taxes, and PMI, if required. Once they’ve determined how much of a monthly payment you can afford, they extrapolate how big of a mortgage for which you qualify.
Due to the nature of these calculations, the down payment only increases the total size of the mortgage you qualify for on a dollar-for-dollar basis.
That is, if you qualify for a $150,000 mortgage and have an extra $10,000 to put down, you can qualify for a $160,000 mortgage. But since existing debt impacts how much the bank thinks you’re able to pay, it limits the size of your mortgage as well.
In fact, paying off debt will increase the mortgage amount you qualify for by about three times more than simply saving the money for a down payment.
Thus, generally speaking, it makes the most sense to pay down existing debt if you want to max out your loan amount.
There’s another aspect to this consideration as well. The interest rate on credit card debt is often much higher than the interest rate on a mortgage, and it certainly holds true in Jim’s case. Moreover, you can deduct mortgage interest on your taxes, and thereby further reduce the rate you effectively pay on your home loan.
Since it’s almost always better to trade high-interest debt for low-interest debt, Jim’s decision from this perspective is a no-brainer. Not to mention that even if he puts the entire $20,000 down payment toward his home, he must still pay PMI, which is an added monthly expense if the down payment is less than 20%.
But there are a few situations in which putting a portion of your down payment toward debt isn’t necessarily the smartest move:
If you can decrease your minimum payment requirements
Since the bank uses your minimum required payments to calculate how much loan you can afford, decreasing minimum payments, even temporarily, may increase your loan amount without you having to pay off any debt. Moreover this is best done with loans you want to keep, those with interest rates near or even below your mortgage interest rate.
For example, many student loans fall into this category and may permit you to alter your payment plan for a year or two, thereby making it easier to qualify for a larger loan without having to pay any of the low-interest student debt off.
or credit card debt, in addition to asking your company for a reduction in your minimum payment requirements, you could consider a balance transfer to a credit card with a lower APR rate or a promotional period free of any interest. However, don’t open a new card too close to the time you apply for your mortgage, as this can hurt your credit score in the short-term.
2. If you can’t afford much of a down payment
While zero-down-payment mortgage options do exist, you’re ly to pay much higher interest rates. Saving up your money so you can provide even a small down payment, 3.5% for example, may save you more money in the long run than paying off your debt.
However, this depends on if you can even qualify for a low or no down payment loan, what interest rate you’ll be offered, and the current interest rate on your existing debt.
3. If you can avoid paying private mortgage insurance
If not paying off any existing debt will allow you to provide a down payment equal to 20% of the sales price of your home, you can avoid paying private mortgage insurance. This may save you money over time as long as the interest rate on your existing debt is not very high.
4. If you don’t need to max out your loan amount
If you don’t need to qualify for a large loan, save your cash instead to have on hand at the closing and when you move into your new home. This is when unexpected expenses are ly to crop up and you can avoid taking on additional debt by paying for them out-of-pocket.
If you’re in the market for a mortgage, try playing around with Bankrate’s New House Calculator, which generated the numbers used in the case study above.
First, find specific houses you’re interested in. Then, plug in the price, property tax information, and an estimate of homeowners insurance costs into the calculator.
(Try asking other homeowners or a local insurance agent for an insurance estimate.)
See how much you qualify for initially and if paying down debts will increase the amount. Don’t forget to account for interest rates on your existing debt either. For example, even if you can reduce your mortgage rate a full percent by increasing your down payment, at what interest is the debt you could have otherwise paid off? Remember, home mortgage interest is deductible on your taxes.
If you’re just starting to look for a home, play around with the calculator above and consider the different ways to spend your down payment. Don’t leave it entirely up to the bank to decide what you can afford either.
If the bank thinks you can handle a $2,000 per month mortgage payment, but you know you can’t, don’t get into one just because the bank says so.
Find a house you can comfortably afford, so you can be confident to make all your monthly payments and enjoy your new home stress-free.
Have you ever been faced with the decision to save for a down payment on a house or pay off debt? Which did you go with and why?
Should I pay off debt before buying a house?
Low mortgage rates have encouraged many people to buy homes for the first time, even those with consumer debt.
Some potential homeowners are hesitant to seek out a mortgage since they have either credit card debt, personal loans or student loans.
Multi-lender sites such as Credible can help guide you as you weigh the pros and cons of a home refinance. Specifically, Credible can compare multiple lenders and refinance rates in one screen so you can see if you could save money and cut the life of your loan through the process.
Should you be debt-free before buying a house?
Financial experts recommend that consumers consider these five factors before they obtain a mortgage:
- Should I take a mortgage out with existing credit card debt?
- Pay off debt first
- Considerations before buying a house when they already carry debt
- How to pay off credit card debt quickly
- How it impacts couples with credit card debt who want to buy a house
1. Should I take a mortgage out with existing credit card debt?
People who still owe money on their credit cards can qualify for a mortgage, but it depends on how much they owe compared to their salary and other savings. The amount of credit card debt you have will impact the amount you can borrow to buy a house and receive one with good rates and limited costs, said Leslie Tayne, a Melville, NY attorney specializing in debt relief.
“Consumers should consider checking their debt-to-income ratio before buying a home and existing credit score along,” she said.
To see if you qualify for a mortgage your current credit score and salary, head to multi-lender marketplace Credible.
HOW TO GET A MORTGAGE RATE BELOW 3%
2. Pay off debt first
Paying down as much debt as possible before applying for a mortgage is ideal since it helps consumers improve their credit score, which mortgage lenders use to decide the interest rate a homebuyer will receive.
“Becoming completely debt-free from credit cards might be unnecessary and unrealistic,” Tayne said.
If you want to take advantage of today's low mortgage rates and you've paid off your debt (or believe you have a good credit score as it stands), make sure you use Credible's free online tools to start saving today.
3. Considerations before buying a house when they already carry debt
Having less debt means it can free up a homeowner’s budget since there are other costs to factor in each month, including property taxes, maintenance fees and other bills.
Applying for a mortgage when you have credit card debt is not a deal-breaker as long as what you owe does not exceed the lender's debt-to-income ratio guidelines.
Typically, lenders look for a ratio of 36% or less and arrive at that figure by dividing your monthly debt payments by your monthly gross income, said Bruce McClary, spokesperson for the National Foundation for Credit Counseling, a Washington, DC-based non-profit organization.
Use an online mortgage calculator to determine potential monthly payments or plug your numbers into Credible and see your estimated mortgage rates and monthly payments.
4. How to pay off credit card debt quickly
Beyond paying at least 10% more than the minimum monthly payment, consumers should consider affordable balance transfer or debt consolidation options.
If you think a debt consolidation loan might be the best choice for you, visit an online marketplace Credible to get a sense of your options.
You can also utilize Credible's tools to browse balance transfer and other credit card options instantly.
“As long as you can lower interest and fees as a result, you will come out ahead,” McClary said. “You shouldn’t take on any new debt or open new accounts just before applying because it could be a red flag in the approval process.”
Consider prioritizing and paying high-interest debt first.
“Budgeting allows borrowers to see the big picture in terms of money coming in and going their accounts each month,” Tayne said. “After bills are paid, leftover money can be used to make a sizable dent in their debt, which can improve the borrowers' chances of receiving loan approval quickly and with fewer costs.”
4 THINGS TO DO WHEN BUYING A HOME
5. How it impacts couples with credit card debt who want to buy a house
Couples should discuss their credit scores and history before they apply for a mortgage because they're both being considered. The total amount of debt can impact the amount of a mortgage that you can qualify for together.
If your unsecured debt is $250 a month, it could reduce your potential purchase price by approximately $50,000, while $500 a month could reduce your potential purchase price by around nearly $100,000, said Jackie Boies, a senior director of housing and bankruptcy services for Money Management International, a Sugar Land, Texas-based nonprofit debt counseling organization.
“Carrying debt into the process will make it harder to qualify for a loan and to live comfortably after your purchase,” she said.
Credible can help you compare multiple mortgage lenders at once in just a few minutes. Use Credible’s online tools and get prequalified today.
Meeting with a housing counselor from a non-profit credit counseling agency can be helpful since your financials are reviewed and other important factors such as your credit score, debt-to-income ratio and down payment plans are discussed.
“You’ll develop a realistic budget and come away from that session knowing if you can truly afford to purchase a home,” Boies said. “Your counselor will issue a certificate of counseling, which you can present to the lender you choose.”
WHAT IS THE BEST MORTGAGE TERM TO TAKE?
Should You Pay Down Debt Before Applying For a Mortgage?
This blog was contributed by Tony Gilbert of RealFX.com
A question many potential home buyers ask when applying for a mortgage is: Should I pay off debt before applying for a home loan? Credit card debt, auto loans and other forms of debt can all have an impact on a person's credit score, which in turn affects the rate they are able to get on their mortgage (or their ability to qualify in the first place). The answer isn't always as simple as a yes or a no, but there are a few figures to keep in mind that can aid in making this decision.
Potential home buyers that may have too much debt may limit the size of mortgage they are qualified to borrow.
On the other hand, those who pay off debt too close to the date of application may experience other issues while obtaining a mortgage due to fluctuations in their credit score.
Understanding the loan process, including what factors underwriters consider when they're approving a home mortgage, may help potential home buyers decide whether or not paying off debt is the correct decision for them.
Debt to Income Ratio
The debt to income ratio is an important factor that can influence how much a home buyer is approved to borrow. The ratio is important to mortgage lenders because research shows that borrowers who have too much debt are more ly to default on their loan.
The debt to income ratio is calculated by dividing a borrowers debt payments by their gross monthly income.
For example, a home buyer who has a $500 per month car loan, $500 credit card payment with a $5,000 gross monthly income has a 20 percent debt to income ratio ($1,000/$5,000=20%).
If that homebuyer were to be approved for a home loan with a $1,000 per month house payment, his or her debt to income ratio would then become 40 percent ($2,000/$5,000=40%).
In most cases, the maximum debt to income ratio that a home borrower can have and still be approved for a mortgage is 43% (including the future mortgage payment).
A borrower who has too much debt to be approved for a mortgage may need to pay down their debt in order to proceed with the mortgage process.
And, a potential home buyer who may desire to qualify for a higher loan amount (a more expensive home) than their debt to income ratio allows may also need to pay down some debt.
Debt and Credit Scores
Many people assume that a lack of debt is good for a credit score. In fact, the reverse is often true in a sense.
A small, healthy amount of debt is good for a credit score if the debt is paid on time every month.
For example, a car loan that is paid monthly shows that the borrower is reliable and responsible with debt in the eyes of a lender. Every timely payment contributes to the borrower's good credit score.
Eliminating that debt by paying it off before the mortgage application could potentially negatively impact the borrower's credit score, even if only temporarily. While the drop is often only a few points, and the credit score is ly to rise again fairly soon, paying debt off during or right before the mortgage process could have negative consequences for a buyer.
Mortgage underwriters often frown on any changes to a person's credit score in the crucial days before funding a loan. In addition, a borrower who may have a borderline acceptable credit score at the beginning of the loan process but then experiences a sudden drop at the end of the underwriting process, may not be approved for the loan or be approved at a higher interest rate.
Cash on Hand for the Buying Process
Paying down large amounts of debt before the mortgage process might also be problematic as many potential home buyers may need the cash on hand for the home purchase. In most cases, a home buyer will need some cash when buying a home for the following items:
- Down payment: The cash down payment is often anywhere from 3.5% of the loan to 20% of the loan.
- Closing costs: In most cases, buyers will be expected to pay some closing costs.
- Relocation expenses: Moving expenses can be costly depending on the distance, how much is being moved and whether or not a full-service mover is hired.
- Remodeling: Home buyers typically make some improvements to their current home to help it sell, or they might wish to remodel their home after a purchase.
The Bottom Line
Paying off debt before applying for a loan can have a positive or negative effect on a home buyer's plans. It's up to buyers to identify which situation they are in. Potential home buyers (especially first-time buyers) often need guidance and advice before applying for a mortgage or for other types of loans.
Borrowers should strongly consider speaking with a financial advisor or mortgage broker before making any big decisions. Additionally, home buyers who are currently in the mortgage process should maintain close contact with their lender during the process.
Any financial changes of the borrower, both positive and negative, should be always be discussed and disclosed with the lender to ensure a smooth lending process.
Should I Pay Off Debt Before Buying a House?
A reader and her husband want a new house, but they don't want old debt, either.
Question: My husband and I got married two years ago next month, and we’d to buy a house. We’re not ready to start a family just yet, but it seems home prices are just going to go higher. My husband thinks now is the time to strike. Plus, we’ve seen ads for some really low mortgage rates.
The problem is this: We have, between us, about $14,000 on eight credit, store, and gas cards. I’m wondering if we should use some of the money we’re saving for a house and pay off some of those cards. But then, home prices might go even higher, and we’ll have missed our chance.
Is there a math formula for figuring this out?
— Hope in Pennsylvania
Here’s the only math formula that matters: Do you earn enough money to pay both your debts, closing costs, and a monthly mortgage?
The reason this country faced a housing bubble and a terrible recession a decade ago was simple: For many Americans, the answer was “no.”
Four years ago, I wrote a book called Power Up. This part speaks directly to your situation, Hope…
In the past, millions of Americans got themselves into some nasty predicaments because they bought homes they couldn’t afford.
They took out exotic mortgages and decided not to analyze the downside to these mortgages, which were costly and have a negative impact on cash flow.
They were so enamored of what they thought they could buy (note, I said buy, not afford) that they decided to ignore the fatal risks.
The real question here is, “Do you need a house right now?” Interestingly, Hope, I was just recently reading about a study by the Pennsylvania Association of Realtors that shows, “One in 3 new homeowners are categorized as want to buy customers, while more than 1 in 4 are need to buy customers.”
What’s the difference? Well, think of it buying a car. When you need a car right now because yours finally died, you’ll overpay. You certainly don’t want to do that with a house.
Bottom, line: Pay off your debts first.
You mentioned math, Hope, so let’s do some. You have around $14,000 in credit card debt. The average credit card interest rate is about 15 percent a month. So you’re being charged nearly $600 a month just in interest.
Imagine that $600 going toward a monthly mortgage payment!
If you and your husband can pay off your credit cards, you can then take the money that formerly went to debt and put it into a savings account for your house.
Another Debt.com expert and host of the Money Girl podcast, Laura Adams, agrees with me…
Laura Adams, author, and host of Money Girl podcast responds…
The types and total amounts of debt you can handle depend on your goals and the bigger picture of your finances. But in most cases, you should opt for paying off the credit card debt first. Here’s why.
A mortgage is considered “good debt”
In some cases, using debt is a smarter move than spending cash, especially for a home. That’s because mortgages are relatively inexpensive debt. The average 30-year fixed-rate mortgage cost about 10% in 1990, but today (2019) 4% rates are widely available. There’s also been hints that the Federal Reserve may lower rates, which could drop mortgage rates even lower.
One reason a home loan comes with a lower interest rate than other types of debt, such as credit cards or personal loans, is because it’s secured by the property you purchase. Not only can a lender foreclose or take your home back if you don’t pay a mortgage as agreed, but you also go through a strict approval process.
The tax benefits of mortgages
Another unique benefit of having a mortgage is that it can cut your taxes if you claim the mortgage interest tax deduction. A tax deduction saves money because it reduces your taxable income, which lowers the amount of income tax you have to pay.
When you borrow money to buy, build, or remodel a home, you’re allowed to deduct the mortgage interest you pay each year. Depending on how much you earn and your tax rate, claiming the deduction could reduce what you owe or increase your tax refund by thousands of dollars.
Beginning in 2018, you can deduct interest paid on your main home and a second home on mortgage balances up to $750,000 (or $375,000 if you’re married and file taxes separately). This is down from $1 million or $500,000 for loans taken out in previous years, which is still deductible.
The main requirements to claim the mortgage interest deduction are that:
- your debt is secured by the property
- you have an ownership interest in the home
- you file taxes on Form 1040 and itemize deductions on Schedule A.
Another financial goal you may have missed
There is another financial goal besides paying off debt that you didn’t mention and that’s savings. If you’re not saving at least 10% to 15% of your income for retirement, then you may want to prioritize that goal instead of paying off any debt ahead of schedule.
You might also want to consider using some of the funds for emergency savings, if you don’t have an emergency fund set up.
Once you send money to a lender to pay off a loan or credit card early, you can’t get it back if you fall on hard times or have unexpected expenses.
A good rule of thumb is to always keep an emergency fund equal to at least three to six months’ worth of your living expenses.
Even though there are advantages to having a mortgage, you should never get one that’s more than you can afford. Make sure you can handle the monthly payment, plus property taxes, insurance, any homeowner association dues, and estimated annual home repairs.
Having a mortgage allows you to save and invest more money than you otherwise would. So, I recommend taking out a mortgage and using your cash to beef up your emergency fund and save more for retirement, if you aren’t already. Otherwise, pay the credit card debt from highest to lowest interest rate. Paying off a low-rate mortgage should be the last financial priority.
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Pay Off Credit Card Debt Before Applying For A Mortgage
Over half of U.S. adults (55 percent) owning credit cards say they also have debt, according to a 2019 CNBC Make It and Morning Consult survey. For people applying for a mortgage loan, credit card debt can pose a problem.
If you don’t qualify for the lowest possible rate, you’ll owe thousands of extra dollars in interest over the life of the loan.
You can also be denied a mortgage loan if your credit card balances are too high or your payment history lowers your credit score beneath the required threshold.
Should you pay off all credit card debt before getting a mortgage? In some cases, especially if your current credit score makes you ineligible for a mortgage loan, it’s a good idea to pay down credit card debt. But credit card debt isn’t the only factor in getting mortgage approval. There are several variables you need to consider if you carry debt and are looking to be approved.
You don’t need excellent credit, but it helps
A home is one of the single biggest purchases the average American will make. With the median price of a home in the United States now $243,225, the interest rate you receive really matters.
For instance, the difference between a 3.5 percent and 4.0 percent rate means $56 dollars a month on a $200,000 mortgage. That $56 isn’t just money you get to keep in your wallet, either. The lower the interest rate is, the bigger the principal payments you’ll make each month. You are actually building equity faster when you have a lower interest rate.
When you look online, the low rates you see are “teaser rates,” typically only available to people with excellent credit (a score of 780 or above). It’s important to have a realistic sense of what your rate will be your current credit score.
Paying off your debt can raise your credit score, but it’s not always necessary to have an excellent score in order to end up with a competitive interest rate.
If you have a good to very good score (at least 620) and qualify for a private mortgage loan (580 for an FHA loan), you can usually buy a “point” for an additional 1 percent of the loan value in order to reduce the interest rate from, say, 5 percent to 4 percent. Over the long haul, that could be a good investment.
Another option is to hold your mortgage for a few years, allow equity to build and then refinance to a lower rate. This can be a riskier strategy since mortgage rates could climb, the price of real estate could drop or both.
What about debt-to-income ratio?
Having credit card debt isn’t going to stop you from qualifying for a mortgage unless your monthly credit card payments are so high that your debt-to-income ratio is above what lenders allow. Banks and other mortgage lenders obtain your debt-to-Income (DTI) ratio by dividing your monthly debt by your gross (pre-tax) income.
There are actually two different DTI ratios that a mortgage lender may consider:
- The front-end ratio divides your monthly household expenses, including the mortgage payment, by your gross income. You typically need to stay below 28 percent to be approved.
- The back-end ratio takes your total debt payment into consideration, including your credit card payment. The figure you need to stay below is 36 percent.
Lenders generally consider the back-end DTI ratio more significant, and if it’s above 36 percent, you’ll have a hard time qualifying for a loan. Neither DTI ratio takes into consideration things food and gas each month, and some don’t consider installment debt that is almost paid off.
There are several ways to pay down credit card debt before you apply for a home mortgage loan, but some of them can affect your credit score in the short-term.
For instance, if you get a new credit card with an introductory zero percent APR, you’ll see a slight hit to your credit just for having a hard inquiry on your account.
This is something to keep in mind if you plan on applying for a mortgage loan within a few months.
Another way to pay off debt is to get a personal loan from friends or family members. Just remember that lenders calculate DTI your monthly payment amounts, not your credit card balance. Paying off some of a credit card loan won’t affect your DTI that much — though it could be just enough to put you below 36 percent.
Credit card debt is costly to own and should be the first thing you target in a debt-reduction strategy. But if you’d to buy a house right away, it won’t necessarily be an impediment to loan approval 9provided that your DTI percentage is low enough and you have good to excellent credit).
Finding the top mortgage rates you qualify for is the first step to starting your journey. Once you own a home, you’ll be able to build equity and net worth, which can lead to even more debt-reduction options.