Should you pay off your debt before you start saving for a home? That’s the question that many hopeful homeowners ask themselves, and while many choose to go ahead with a home purchase while carrying debt, you’re about to find out why that may not be a good idea.
Paying off your debt before saving for a home has several advantages. First, it affects your ability to qualify for the best mortgage rates. Paying off your debt will also increase your disposable income (once you’re free of those monthly payments), which will increase the maximum home price you can afford.
But not all debt is created equal. Let’s look at which types of debt should be paid off before saving for a home, and which debt you can safely carry into home ownership.
Pay off your high-interest debt
If you have high-interest debt such as credit card debt, you should pay it off before you start saving for a home. Having several maxed out credit cards (or even credit cards that with nearly maxed out balances) will lower your credit score, and a low credit score may prevent you from qualifying for the best mortgage rates.
Qualifying for the best mortgage rate is important because even the difference of a few tenths of a percentage point on your mortgage rate can cost you thousands of dollars in interest over the life of your mortgage.
At the very least, you should bring the balance on your credit cards to under 35% of the total available balance. Anything above that will lower your credit score.
To put yourself in the best possible financial position before homeownership, pay off your high-interest debt before saving for a home.
Pay off your high-volume debt
If you have tens of thousands of dollars of debt, such as from your education, you should pay off it off before you begin saving for a home. You should pay off this debt because a large volume of debt comes with a hefty monthly payment, which will affect how much home you can afford. It all comes down to your debt service ratios.
When you apply for mortgage pre-approval, your lender will use debt service ratios to determine your maximum affordability.
One of them, the total debt service ratio (TDS), determines the monthly amount you can afford to pay for housing. The ratio adds up your housing expenses, credit card interest, car payments, and loan costs, and divides that amount by your income. The ratio must be equal to or less than 40% for your lender to feel comfortable lending to you.
If you have debt, your TDS ratio will be negatively affected, and you’ll be pre-approved for a smaller mortgage.
For example, let’s say you have a pre-tax income of $80,000 per year ($6,666 per month). You also have $40,000 in student loans at 5.5% interest amortized over 10 years, and you have a monthly payment of $434.11. You have no other debt.
According to your TDS ratio, you can afford monthly housing costs of $2,232.29, which translates to a $464,504 maximum purchase price assuming a $50,000 down payment and a mortgage amortized over 25 years at today’s best mortgage rates.
If you paid your student loans off, you’d no longer be hindered by your debt obligation and your maximum affordability would increase to $482,863.
Is is okay to have debt while saving for a home?
There are some instances where having debt won’t adversely affect you, and you can begin saving for a home right away.
If you have a small amount of low-interest debt, such as a small car loan, it won’t have a significant effect on your credit score or your debt service ratios. A small amount of low-interest debt is the least detrimental debt to your home ownership prospects, and there isn’t much of an advantage to paying off that debt before saving for a home.
But if you have high-interest debt or a significant amount of debt, you should pay it off first before saving for a home. Debt management is part of good fiscal responsibility and is good practice for the financial management skills that’ll come in handy once you become a homeowner.
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Flickr: Got Credit