Qualifying for a mortgage requires many things. You need money for a down payment, but you also need a low debt-to-income ratio. If you’re in over your head in debt, you may not get approved. But, if you don’t have a down payment, your loan options are limited.
So which should you do – pay off debt or save for a down payment? It depends.
What’s your Debt Ratio?
Your debt ratio is one of the most important aspects of the mortgage application process. Too many debts make you ineligible for a loan. How much is too much? It depends on your income and the loan program.
Lenders look at your total debt ratio. This compares your total monthly debts (new mortgage included) to your gross monthly income. Think of debts like your credit card payments, student loans, car loans, and installment loans. Lenders total the required monthly payments and divide that by your gross monthly income. For example:
- Total monthly debts $1,500
- Gross monthly income $4,000
- Debt ratio = 37.5%
Lenders then determine which loan program you fall into:
- Conventional loans – Max housing ratio 28% and max total debt ratio 36%
- FHA loans – Max housing ratio 31% and max total debt ratio 41%
- VA loans – Max total debt ratio41% (they don’t have a max housing ratio)
- USDA loans – Max housing ratio 29% and max total debt ratio 41%
A 37.5% total debt ratio is in line with FHA, VA, and USDA loans, but not conventional loans.
If you have a debt ratio of say 55%, for example, you exceed all maximum debt ratios allowed. In that case, paying off your debt makes more sense.
Find the perfect balance between paying debt down/off and saving for the down payment. Chances are that you’ll need some money down unless you qualify for a USDA or VA loan.
How Much can You Save?
20% down payments aren’t required anymore. Sure, it’s great if you have it, but if you don’t, there are other options including:
- Conventional loan minimum down payment 5%
- FHA loan minimum down payment 3.5%
- VA and USDA loans don’t require a down payment
You can get a loan with as little as 3.5% down. On a $200,000 loan, that means $7,000. FHA loans also have lenient underwriting guidelines. With higher debt ratio allowances and lower credit score requirements, you may find it easier to get approved.
Now, if you don’t have a lot of debt, go ahead and save more for the down payment. Most people today, however, have some type of debt. You’ll need to look at the big picture.
What Can you Afford?
Think about what you can afford. Don’t look at the numbers above – those are guidelines. What can you truly afford? Look at your budget. Plug in the numbers. How do you feel about the large mortgage payment?
If you already have a lot of debt and adding a mortgage payment to it seems overwhelming, pay down your debt. But, if you have minimal debt or you can handle the payments, save for the down payment. You’ll have more equity in your home and earn a greater return on your investment.
No Two People Will Have the Same Answer
Paying down debt or saving for a down payment is a personal decision. What are you comfortable with? Remember, taking on a mortgage payment is a big responsibility – one that lasts for the next 30 years, possibly.
If you feel better making a large down payment, then save for it. If you don’t mind borrowing a large percentage of the sales price, get out of debt. Your mortgage interest rate will likely be much lower than any interest rate you pay on consumer debt. Get yourself out of it and stay out of it as long as you can.
If you can find the perfect balance between paying debt down/off and saving for a down payment, it’s ideal. You can have equity in your home, not feel overwhelmed with the monthly payments, and get the best of both worlds.