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.
Based on 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:
1. 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, like 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 likely 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 likely 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?