Should You Pay Off Debt Before Buying a House?
“Should you pay off debt before buying a house” is a commonly asked question buy many under 40. The 2020-22 Housing Market in particular has been difficult for new home buyers to navigate.
How to Manage Debt before Buying a Home
What is a Debt-to-Income Ratio
Lenders use the debt-to-income ratio to determine if borrowers can afford a mortgage payment and other debts (DTI).
Calculated by dividing monthly debt payments (future mortgage, credit cards, student loans, vehicle loans, etc.) by total monthly income (before taxes).
Lenders prefer borrowers whose aggregate debts do not exceed 43 percent of gross income. This is important when you need to pay off debt before buying a home.
Here’s one example:
Suppose a couple has monthly vehicle payments of $600, school loan payments of $240 and credit card payments of $200, and wants a $2,000 mortgage payment. Their DTI ratio is 38% ($3,040 is 38% of $8,000).
Our couple is on pace to acquire their financing. If they desired a bigger loan, they might pay down their credit card debt before applying.
By the way, that 43% mark isn’t fixed in stone. In some cases, mortgage lenders will grant exceptions depending on individual circumstances. It’s still good to know where you stand before you start looking.
Consider Debt’s Impact on Credit Scores
A bad credit score doesn’t imply you can’t receive a mortgage. Lenders also consider employment history, income, and other variables. Your credit score and credit report information will likely play a big role in determining whether you qualify for the mortgage and interest rate you want.
A FICO® Score of 620 is usually required for a conventional mortgage, however lower scores may be acceptable. Or they may qualify for an FHA or VA loan. In short, the better your credit score, the more loan possibilities you’ll have.
A credit score is determined by several criteria, but payment history and credit usage are the most important. Payment history considers on-time or late payments, as well as bankruptcy.
Credit utilization looks at loans and credit card debt. Credit usage rate is a measure of how much revolving credit you have available vs how much you use. The lower the better. Most lenders prefer a 30 percent usage rate.
So, should you pay off debt before buying a house?
Not necessarily. Debt isn’t the enemy of your credit score. Borrowers who handle their debt wisely and pay on time should expect to keep their score high. Having no credit history might sometimes be an issue when applying for a loan.
Consistency is crucial, therefore borrowers should avoid large payments, purchases, or balance transfers while applying for loans. Mortgage lenders may scrutinize any significant changes in your credit score.
Don’t Forget: You Might Need Cash Right Now
Making large debt payments can also pose problems if it leaves you short on cash for other things you might need during the homebuying process, such as the items listed below.
Making a Down Payment
You’ll want to have that money available when you find the home you want to buy, whether you want to put down 20% or less (the median down payment for recent buyers was 12%, according to a 2021 National Association of Realtors® report).
Costs of Closing
Home appraisals, inspections, title searches, and other fees can quickly add up. Closing expenses typically range from 2% to 5% of the total loan amount.
Expenses of Moving
Even a nearby move might cost hundreds or even thousands of dollars, so make sure to prepare for moving costs. If you’re relocating for employment, your company may cover some or all of your expenses, but you may have to pay up front and wait for reimbursement.
Costs of Remodeling and Redecorating
You may want to set aside some money to cover any new furnishings, paint, renovation work, or other costs associated with moving into your new house.
Keep an eye on the current state of the housing market.
Housing market trends may assist you in prioritizing savings or debt repayment. As a result, keeping an eye on the entire economy, your local real estate market, and real estate trends in general is a good idea.
Here are some things to keep an eye out for.
Homeownership is more affordable when loan rates are low. A lower interest rate minimizes the long-term cost of buying a property by keeping the monthly payment low.
Rising interest rates, on the other hand, aren’t necessarily a bad thing for purchasers who have been having trouble finding a home in a seller’s market. A seller may be more willing to negotiate and cut a home’s listing price if higher rates narrow the herd of possible purchasers.
In any case, it’s beneficial to be informed of where rates are and where they may be headed.
When you begin your home hunt, you should look into the typical period homes in your target location spend on the market. This can give you a decent idea of how many houses are for sale in your neighborhood and how many people are looking. (You can receive this information from a local real estate agent.)
You might have problems locating a house at the amount you want to spend if inventory is low and buyers are snatching them up. A buyer’s market exists when inventory levels are strong, and you may be able to negotiate a lower price on your desired property.
If you overpay and then decide to sell, you may have a difficult time recouping your investment.
Of course, after you get your financial ducks in a straight, the goal is to find the perfect home at the right price, with the right mortgage and interest rate.
If the trends indicate that you should wait, you may want to focus on paying off your obligations and improving your credit score.
You Can Modify Your Mortgage Terms if Needed
If you currently have a mortgage, refinancing to a different term can help you make some changes to the original loan.
Borrowers who want a cheaper interest rate, a shorter loan term, or the ability to avoid paying private mortgage insurance or a mortgage insurance fee can benefit from refinancing.
Consider a Debt Payoff or Reduction Plan
If you want to pay off debt before buying a house, it helps to have a plan.
But here’s the thing: not all debt is equal. Credit card debt has higher interest rates than other types of borrowing, making it more costly to carry over time. Also, lenders often view student loans as “good debt” and credit card debt as “bad debt,” so they may be more lenient when you apply for a mortgage. (Car loans are usually classified as a mix of the two.)
As long as you’re paying your bills on time, it may make sense to focus on paying off credit card debt.
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