Buying a house is a large investment, and it can be daunting, especially if you have existing debt that you are paying off; credit cards, auto loan, student loan(s), etc.
So you may be asking yourself, should I pay off debt before buying a house?
You would think that the answer to this question would be a simple yes, since having less debt is better when taking on a new debt, right? In reality, the answer is a little more nuanced.
While paying down, or completely paying off debts can be helpful in freeing up some extra cash that can be put towards a down payment, closing costs, and subsequent monthly mortgage payments, it is important to understand the relationship between debt and the mortgage process.
A helpful place to start is understanding what mortgage underwriters are looking for.
Underwriting is a crucial part of the mortgage process, and is ultimately the deciding factor in whether or not you’ll be approved for a home loan by a lender. Generally, underwriting occurs behind the scenes while home appraisal is taking place. An underwriter will carefully assess your finances to give the lender an idea of how much of a risk you are, resulting in an approval decision.
Underwriters often look at the following:
So how does your debt affect these and other important mortgage process factors? Let’s take a closer look.
No debt is equal to a better credit score, right?
Well, no actually. A higher credit score requires some responsibly managed debt, meaning that you always make payments on time.
Your credit score is calculated based on your debts and how you manage them. If you don’t have any debt, you won’t have a credit history, and lenders won’t be able to verify how you manage borrowed money.
However, lowering debt, instead of eliminating it, could be a helpful practice, particularly to help meet the costs of buying a house and to continue making your mortgage payments. But you should be careful in how you go about lowering debt, because doing too much too soon could have an adverse affect on your credit score.
When you pay off a loan, or any other type of debt, your credit score will temporarily drop; the same occurs if you close credit card accounts. While it may not always be wise to maintain debts for the sole purpose of achieving a high credit score, it is important to understand the timing of paying off debt in relation to applying for a mortgage.
Therefore, a good rule of thumb may be to not pay off debts or close credit card accounts immediately before applying for a mortgage.
Underwriters, who are scrutinizing your credit, generally don’t like to see credit changes immediately before funding a home loan, and so it could be in your best interest to hold off on paying down your debts and/or closing credit card accounts. And, a healthy credit score is required if you want a lower interest rate.
But, how do you know whether or not it’s a good idea to pay off your debts or not?
“People looking to purchase a home for the first time should meet with a mortgage professional who will look at their credit and income to see if it makes sense for them to pay down or pay off debt to get approved for a better loan,” says Gelios. “If a first-time homebuyer can get approved for a higher amount they want or need while getting a better rate if they pay off debt and increase their credit scores, then that is the route they should go.”
As was mentioned earlier, your DTI ratio is how much credit you use in relation to your income, and is typically presented as a percentage. This ratio is the second largest factor, after making on-time debt payments, that makes up your credit score.
“Most lenders like to see an applicant's Debt-to-Income ratio at or below 43 percent when applying for a home loan. This is the monthly debt obligation divided by the gross monthly income.” says Gelios. “For example, if an applicant has $1,000 (Monthly Debt) and $2,000 in Gross Monthly Income, their DTI would be 50 percent. So at this point an applicant would need to pay down or pay off debt to bring that percentage down.”
This ratio is particularly important to underwriters because it is common that individuals with too much debt (or a high DTI ratio) are more likely to default on their loan. Thus, if you have too much debt, you may need to pay it down before applying for a mortgage.
You may be thinking that it would be best to just eliminate debt entirely and not worry about this ratio, but remember that some debt is good and is important for maintaining a healthy credit score.
What do you do when you have some extra income? Would it be better to pay down your debts or put that money aside in savings?
While it can be helpful to consider the cost of interest on your debts, or simply splitting your income in half to cover all your bases, one important consideration is whether or not you already have an emergency fund or not.
An emergency fund is exactly what it sounds like: savings put aside for an emergency.
Especially when buying a house, it is important to have some money set aside for unexpected circumstances from roof repair after a storm, to medical expenses that you wouldn’t be able to easily cover while also making mortgage payments, or even to unexpected job loss. In general, it is always advisable to be prepared and have some extra money in the bank.
In most cases, experts advise having three to six months worth of expenses in an emergency fund. While this can vary depending on your circumstances, as well as the debts that you are paying off, setting aside whatever you can is a good idea.
In the end, the decision to pay off debt or save money is a personal decision and will depend on your circumstances.
Should I pay off debt before buying a house?
Whether you have existing student loan debt or credit card debt, it is generally a good idea to pay debt down before buying a house. But there are three things to keep in mind that can help you determine the best ways to pay down and/or manage your debts:
If in doubt, talking to a mortgage professional or loan officer can be a helpful way to more accurately assess how to approach your debts before buying the house of your dreams.
Expert contributor: Jason Gelios is an award-winning, top producing REALTOR® and author.