If you have consumer debts, like credit cards or installment loans, you may think that it’s smart to pay the debt off before you buy a home. Is this the right thing to do?
It really depends on your situation. In some cases, a little debt will do you some good. But in other cases, too much debt can hurt your chances of getting approved for a loan. So how do you know which is right for you? Answer the questions below to get a better idea.
Does Your Debt Limit Your Ability to Get a Mortgage?
What you need to know is how much of your income your debt takes up already. Lenders have what they call debt ratios that they must follow. These debt ratios are the maximum amount of your gross monthly income that can be taken up every month. If you exceed the program’s debt ratio, you are considered a high risk of default.
Lenders use two debt ratios – the front-end or housing ratio and the back-end or total debt ratio. The housing ratio is the comparison of your housing payment to your gross monthly income. Typically, your housing ratio can be anywhere from 28% to 31% of your gross monthly income depending on the chosen program.
The total debt ratio is a comparison of your total debts (credit cards, installment loans, and housing payment) to your gross monthly income. The total debt ratio can typically range from 36% to 43%, depending on the loan program.
If you figure out your debt ratio and see that you are going to be way over the total debt ratio, it may be time to pay your debts down a little bit. This doesn’t mean you have to pay your debts off in full, because sometimes that’s not the best choice either. We discuss that in detail below.
Do You Have the Cash Needed to Buy the Home?
You need cash to buy a home – you can’t just take out a mortgage and not put a penny of your own money into the transaction. The type of mortgage you choose will determine exactly how much money you will need. For example, the USDA loan doesn’t require a down payment, but you do have to cover the closing costs, unless you can wrap them into your loan (not everyone can). The FHA loan, on the other hand, requires a 3.5% down payment plus you have to cover the closing costs.
If you use all of your cash to pay your debts off in full and you have nothing left to pay the closing costs or down payment with, you may not qualify for the mortgage. Before you go and pay your debts off in full, consider your money situation. Do you have enough to cover the required down payment plus the closing costs? If you don’t know how much the closing costs will be yet, figure around 5% of your loan amount, as that is the average today.
Is Your Credit Score High?
You should also consider your credit score. Many people think that it’s a good idea to be debt free as that will increase their credit score. Technically, that’s not the case, though. In order to keep your high credit score, you’ll want to keep a little bit of your debt alive.
Having debt gives the credit bureaus a chance to see how you handle it. Do you pay your bills on time? Do you make just the minimum required payment or do you pay more towards your debt each month? Do you keep your outstanding credit at a decent limit compared to your total credit limit? Usually you want to keep it at less than 30% of your available credit in order for it to positively affect your credit score.
Do You Have an Emergency Fund?
Finally, you need to determine how much money you have set aside for an emergency. If you don’t have any money left, what will happen if your water heater breaks or you need a new roof? If you pay off all of your debts, but don’t leave any money in savings for yourself, you could find yourself in a bind.
This may not affect your chances of getting a mortgage, but it could put you in a difficult financial place. It’s something you should consider before you decide to pay your debts off in full.
So is it smart to pay off your debt before buying a home? It really depends on the situation. Some people have to pay their debts off in order for their debt ratio to fit the requirements. Others can get away with leaving their debts alone. You need to see what your financial situation is like to help you determine what you should do.