You need cash for a down payment to buy a house. But your existing monthly debt payments and credit also affect your ability to borrow, your interest rate, and the lender fees you’ll pay. Which says nothing of financial upsides and downsides to buying versus renting a while longer.
So how do you choose between paying off your debts and savings for a down payment?
It depends on your personal finances, so consider the following factors while you decide how to prioritize your savings.
How Debt Affects Your Mortgage Application
Before getting into the other factors that go into your decision, you first need to understand how lenders review your loan application.
When you apply for a mortgage, the bank or broker looks at your income, your debts, your assets, and your credit history. They use this information to calculate how much to lend you, at what interest rate and points, and with what down payment.
Mortgage lenders calculate two debt-to-income ratios when you apply: a “front-end” and “back end” ratio.
Your front-end debt ratio is based solely on your housing expenses if you were to borrow money to buy a house. Lenders typically cap borrowers’ housing expenses at 28% of their gross monthly income. So, if you earn $5,000 per month, lenders limit your monthly loan payment to $1,400. Housing expenses include your mortgage principal and interest, property taxes, homeowners insurance, and any homeowners’ or condo association fees.
Where it gets slightly more complicated is your back-end ratio, which includes all your monthly debt payments. Lenders usually cap borrowers’ back-end debt ratio at 36% of their gross monthly income. That includes not just your prospective mortgage payment, but all your other monthly debt payments including auto loans, personal loans, student loans, credit card minimum payments, child support, alimony, and any other obligatory payments.
Continuing the example above, say you earn $5,000 per month, but you owe $500 each month on a car loan, $400 toward student loans, and $100 toward credit card balances. Since most mortgage lenders cap you at a 36% back-end ratio, that means a maximum of $1,800 each month going to all your debt payments combined. Since you already have $1,000 going toward other debts, lenders would only approve you for a mortgage with an $800 payment — including principal, interest, property taxes, homeowners insurance, and association fees.
By paying off one or more of those outstanding debts, you can qualify for a much higher mortgage loan.
Your credit score and history determine your interest rate, lender fees, and down payment. While you can buy a home with bad credit, it costs far more, both in down payment and monthly loan payments.
If you have bad credit, consider improving your credit score before you buy a home. Which you can start by paying off your other debts.
That kills multiple birds with one proverbial stone: you eliminate debts, which increases the loan amount you qualify for, and boosts your credit score, which helps you qualify for a cheaper loan with a lower down payment. Wins all around.
Down Payments & PMI
If you put down less than 20% when you buy a home, the lender requires you to pay for mortgage insurance. Among conventional loans, it’s called private mortgage insurance (PMI); among FHA loans, it’s called mortgage insurance premium (MIP). It can add $100 or more to your monthly payment.
The distinction matters, because conventional loans allow you to remove PMI once you pay the balance down below 80% of your home’s value. However FHA loans no longer allow that — they require you to keep paying MIP for the entire life of your loan. That means you should avoid FHA loans if possible, and the better your credit score, the better your odds of getting a conventional loan.
When you take out a conventional loan, you ideally want to put down 20% to avoid PMI entirely. It adds another wrinkle to the decision of whether to put more money toward a down payment or toward paying off debts. But even if you borrow more than 80% of the home price, at least you can remove PMI once you pay down your loan balance.
Non-Mortgage Factors Affecting Your Decision
Your mortgage approval and loan terms aren’t the only factors that go into your decision.
Consider the following as well, as you decide what makes most sense for you.
Cost of Renting vs. Owning in Your Market
In some markets, it costs far more to own a home than to rent an equivalent one. And vice versa in other markets.
Look no further than San Francisco. People love to complain about rents in San Francisco, but they’re a steal compared to home prices.
The median rent for a three-bedroom home in San Francisco is $4,567 per RentData.org, while the median home price is $1,504,311 per Zillow. At a 4% mortgage rate for a 30-year loan, principal and interest comes to $7,182 per month. At a property tax rate of 1.1801%, property taxes on a median home come to $1,479 per month. Add another $200 for homeowners insurance and you have a monthly housing payment of $8,861 — nearly twice the cost to rent. And that says nothing of home maintenance and repairs, which renters delegate to their landlord.
In markets where it costs more to own than rent, there’s little rush to become a homeowner. Prioritize paying off debts over saving for a down payment.
How Long You Plan to Stay
American culture has built a mythology around homeownership. But as demonstrated above, it doesn’t always make sense.
Nor are market rent and home pricing the only reason to rent. Renting allows flexibility: you only commit to one year at a time, if that. When you buy a home, it takes years to build enough equity to cover both your initial purchase closing costs and your subsequent selling costs.
If you don’t know how long you want to live in your next home, rent rather than buy. Take the time to pay down debts and improve your credit score.
That goes doubly if you’re thinking about buying a home with a partner, but you’re not 100% confident in your long-term future together.
The Interest Rate on Your Other Debts
The interest rates on your other debts matter. The higher they are, the more urgently you should pay them off. A 5% interest rate on a car loan comes with far less urgency than a 50% rate on a loan from the mob, to use an extreme example.
While you may not owe the mob, many Americans do carry credit card debts with interest rates ranging from 15% to 30%. Consider any loan with an interest rate in the double digits “urgent.”
Bear in mind that it often makes sense to pay off one debt but not another before saving money to buy a home. For instance, if you have credit card debt at 25% interest and a car loan at 5%, consider paying off the credit card balance but leaving your car loan in place.
Your Ability to Suspend or Reduce Other Debt Payments
Since the bank uses your minimum required payments to calculate how much loan you can afford, decreasing minimum payments may increase your loan amount without you having to pay off any debt. It works best with loans you want to keep, such as those with low interest rates.
For example, many student loans permit you to suspend or alter your payment plan for a year or two. That makes it easier to qualify for a larger loan without having to pay off any of the low-interest student debt.
With credit card debt, you can consider a balance transfer to a credit card with a lower APR rate or a promotional period free of any interest. Don’t open a new card just before you apply for your mortgage however, as this can temporarily ding your credit score.
Your Appetite for House Hacking
I don’t have a housing payment, and it makes a huge impact on my savings rate.
Consider getting creative and exploring ways to house hack. In the traditional model, you buy a multifamily property and move into one unit, while renting out the others. Your neighboring tenants ideally pay enough in rent to cover your monthly mortgage payments and some of your maintenance costs.
Alternative house hacking models include bringing in housemates, renting out a basement or garage apartment, renting part of the home on Airbnb, or any number of other house hacking tactics.
I’ve known renters who found ways to house hack. But you have more options when you own your own home.
If the idea appeals to you, and you’re willing to do some research on how to make it happen, buying a home sooner rather than later often makes sense.
Access to Other Funding Sources for Your Down Payment
Some people have family members who might help them out with a down payment — but would never give them money to pay off credit card debt that they racked up through their own financial mismanagement.
In those cases, you can put your own savings toward paying off debts, and accept loans or gifts from family members to help with your down payment. Keep in mind that conventional mortgage loans don’t technically allow you to borrow the down payment, but they do allow gifts.
You can also pull money from your retirement accounts to cover your down payment, tax- and penalty-free. Each retirement account comes with its own rules and limitations for withdrawing funds for a down payment, so do your homework.
Research other creative ways to come up with a down payment. You might find that you can put your own savings toward paying off your debts, even as you raise your down payment elsewhere.
I hesitated to even include this, because too many people overemphasize the importance of the mortgage interest deduction. But Uncle Sam does play favorites with homeowners and allows them to deduct the interest paid on their home mortgage each year, along with their property tax bill.
That only helps you if you itemize your deductions, of course. If you take the standard deduction — as many more Americans now do, after it was raised by the Tax Cuts and Jobs Act of 2017 — the mortgage interest deduction doesn’t impact your taxes at all. The law also put a $10,000 cap on state and local tax deductions on your federal income tax return, limiting your ability to write off property taxes in high-tax cities.
A Framework for Deciding Whether to Pay Down Debts or Save a Down Payment
First and foremost, reevaluate whether you should buy a home right now at all. Research rents versus homeownership costs in your area, and try this nifty rent vs. buy calculator from Realtor.com. Ask yourself how long you plan to stay in your next home, and if you don’t know or if it could be less than three years, continue renting for now while you become debt-free.
If you decide that you definitely want to buy, calculate your back-end debt ratio, and how much money it leaves for a mortgage payment. Don’t forget property taxes, insurance, and homeowners’ association fees. If a 36% cap doesn’t leave you with much room for a housing payment, consider paying off debts. Use the free mortgage limit calculator from Chase to help you run the numbers.
If you’re paying more than 8% to 10% on some of your debts, consider paying them off before saving for a home. Try the debt avalanche method to knock out your highest-interest debts quickly.
In contrast, if you plan to house hack, or if you can raise your down payment from money other than your own savings, consider prioritizing your down payment. Buying a home helps you even more if you itemize your deductions, but don’t base your decision on that factor alone.
Don’t forget to leave yourself an emergency fund, so you don’t find yourself panicking when a $3,000 repair bill comes due 30 days after you settle on your new home.
As you run the numbers in the calculators above, be careful to avoid framing your future housing payment in terms of the most you can possibly afford. It’s a recipe for overspending on housing, and leaving no money for groceries, entertainment, or travel.
Instead, ask yourself “What’s the least I can spend on housing and still be satisfied with my home?” By reframing the question, you’ll look for homes that meet your requirements rather than looking at homes that stretch your housing budget to their absolute limits.
Better yet, skip that game entirely and either house hack or find a job that provides free housing. The suburban American dream of the white picket fence is overrated anyway.