Sean Bryant7-Minute Read
PUBLISHED: July 20, 2022
For many households, debt is a common issue. How much debt is too much? What should I pay off first? Is all debt bad debt? Unfortunately, the answer isn’t clear-cut – it really depends on the individual situation. One thing is for certain, if you’re a first-time home buyer, you’ll want to make sure you’re financially prepared before taking this huge step.
Read on to learn more about good debt, bad debt, and a few tips to get mortgage ready.
Regardless of what you may have heard your whole life, the truth is, not all debt is bad. In fact, the idea that all debt is bad is one of many myths surrounding debt.
When you apply for a mortgage, lenders are going to dig deep into your financial life. They want to see that you’re going to be able to make payments on your loan each month. Your current debt levels – and how you manage them – are a key indicator for them.
So do you need to be debt-free before buying a home? While too much debt is clearly bad, having too little can have a negative consequence as well. Lenders also need to see some credit and payment history before taking a chance on you.
Let’s dig a little deeper to determine the best path for you to take.
If you’re looking to get approved for a mortgage, you need to be aware of the different kinds of debt you currently have. Let’s take a look at some of the most common types people carry, and discuss how they might affect your ability to get a mortgage.
According to a debt.org study, the average American carries $5,315, and the average U.S. household carries $15,706 in credit card debt. But the truly scary fact about credit card debt is that the average interest rate on a new account is 17.98%, and the average rate on an existing account is 14.58%. With rates this high, it can take months, if not years, to pay down the debt.
Credit card debt is widely regarded as bad debt because of its expense, and because high levels of credit card debt is seen as a hallmark of being unable to manage your income and expenses.
The student loan debt crisis has been well-documented during recent years. The cost to attend a 4-year university, public or private, has steadily risen over the past decade. While the COVID-19 pandemic has caused many colleges and universities to reduce tuition costs in 2020, the upward trend is likely to continue. However, unlike credit cards, student loans have much more manageable interest rates, with an average of 5.80%.
There’s no reason to worry if your student loan payments are manageable and you’re up to date. Student loan debt is widely considered an investment in yourself and your future earnings potential. Buying a home with manageable student loan debt should not be a problem; it’s an example of good debt.
Another big source of debt for Americans is auto loans. Like student loans, auto loans tend to have more favorable rates as compared to credit cards.
Debt.org says that 85% of new car buyers and 37.5% of those buying used cars finance their auto purchase. Rates can be as low as 3.9 – 4.6% for people with excellent credit, but can rise to as much as 22.66% interest if your score is 500 or lower.
Are car loans good debt or bad? It’s a split. If you rely on your car for basic transportation to and from work, it’s both a necessity and an investment in your earnings potential. If you’re working from home and you recently purchased a luxury sports car that you’re having trouble paying for, you probably already know the answer.
Buying a new home is an exciting time in your life. Going into the process without the burden of debt is attractive to most people. However, before you decide to pay off debts prior to applying for a mortgage, there are a few pros and cons to consider.
As you pay off debt, your credit utilization will decrease. Credit utilization makes up roughly 30% of an individual’s credit score.
You might be wondering how credit utilization works. Let’s assume you have a total credit limit of $10,000 between two credit cards and a total balance of $4,000. That means your credit utilization ratio is 40%. Many credit experts recommend using no more than 30% of your available credit. However, the closer to zero you get, the greater the impact will be on your credit score.
One factor in determining how much a lender is willing to lend for a mortgage is your debt-to-income ratio, or DTI. This is the amount of debt you have compared to your total income. The lower the ratio, the more house you can theoretically afford. As you pay off debt, this ratio will fall, making you more attractive to lenders.
Essentially, with a higher credit score, a lower DTI and increased down payment savings, you’ll be preapproved more easily. With that in hand, you can begin working with a real estate agent to find your next home.
At a lower interest rate, you’ll save thousands over the life of your loan. See our guide to how credit scores affect your mortgage payment for an example of the direct relationship between your FICOⓇ Score and your monthly payment.
When purchasing a home, it’s typically required that you have anywhere from 3.5 – 20% cash available for a down payment. If you’ve been working hard to pay down debt, there’s a good chance you might not have as much left to cover your down payment as well as the closing costs on a loan.
This means you’ll either need to wait to purchase a home or be willing to use a lower down payment. However, it’s important to understand that your down payment can also affect your interest rate. Lower down payments will usually lead to higher interest rates on your mortgage.
There’s an opportunity cost to waiting for perfection, and if you’re renting, you're losing out on a pot of gold called home equity. As usual, the answer is in your individual mix of circumstances. If your credit is good but not perfect, you may be better off in the long run by applying now – while rates are still low – instead of waiting.
That might not be true for someone with challenging credit who needs to take the time to rebuild their finances. If that’s you, don’t worry – there’s a way back from even the most extreme financial stresses, like bankruptcy.
Your lender will look at your entire financial situation before deciding whether to approve or deny your mortgage application.
We’ve talked about how DTI ratios are a factor in your ability to get a mortgage, but let’s look into them a little further. DTI ratios are the amount of debt you currently have compared to your total income. Higher DTI ratios are typically a negative sign for lenders.
To receive a conventional loan, many lenders will require your DTI to be less than 43%. If you have a lower credit score or have less of a cash reserve, they’ll probably want the ratio to be even lower.
Paying off your debts is going to reduce your DTI and allow you to better afford your mortgage payments each month.
Your credit score is one of the most important numbers that determines your financial health. There are several factors that make up your credit score, but two of the biggest are your payment history and how much of your available credit you’re using. One of the most important things you can do is make sure you’re paying your bills on time each month, even if it’s just the minimum payment.
Higher credit scores can have a lot of positive effects on borrowers. They will typically increase the odds for loan approval, plus they can also reduce the interest rate you’ll receive.
Unless you've already done a lot of research, you might not know that there are many different types of home loans available. Each of these loans has different requirements. Some will come with lower credit requirements, while others might allow you to have a smaller down payment.
For example, government-backed loans, like Federal Housing Administration (FHA), Veterans Administration (VA) and U.S. Department of Agriculture (USDA) loans have easier credit and lower down payment requirements than conventional loans.
Lenders will look at your income and assets when deciding on whether to make a loan. If your credit scores are low or your DTI is high, your lender might ask for a security interest in another asset as well – that’s also if your down payment amount is insufficient to allay their concerns.
When deciding whether you want to pay off your debt before purchasing a house, there are both advantages and disadvantages. But even if you decide that it’s not in your best interest to be debt-free, you still need to make sure you have a good handle on your debt. Here are several tips on how to better manage debt before buying a house.
Earlier we talked about the importance of a good credit score when purchasing a home. Not only will your credit score have a direct impact on whether you’re approved for a mortgage, but it will also impact the interest rate you receive. If your credit score isn't as high as you’d like, spend some time working on bringing it up. To do this, make sure you’re paying all of your bills on time. Pay off as much of your balance as possible at the end of the month to avoid a high credit utilization ratio. By doing these things, your credit score will improve and the cost to finance your house will end up being less.
It’s not fun, but you’ll thank yourself later if you pay off your debt now. How should you go about it? There are lots of ways to do it, but one of the most currently popular is the debt snowball method.
To build your debt snowball, start by organizing your debts from smallest to largest. Next, pay the minimum required on all of your debts except the smallest. Make paying off that smallest debt your top priority until it’s gone.
Allow yourself a small celebration when you accomplish your goal! Now, turn those same resources toward your next smallest debt, and so on, until all your debts are gone.
If you determine that paying down debt isn’t in your best interest, the next thing to consider is refinancing. If you have a student loan balance with a high interest rate, refinancing most likely makes sense.
By refinancing, you may be able to lower your interest rate, which will decrease the total interest you’ll pay on the loan. Refinancing to a lower rate will reduce your monthly payments, but you’ll want to keep paying the same amount each month since this will help pay off the total debt sooner.
If you're paying off many different types of debt – maybe that includes student loans, multiple credit cards and a car loan – it might make sense to consolidate your debt. This could potentially help you lower your interest rate, but it’ll also allow you to start paying one monthly payment instead of several.
Debt consolidation isn’t going to be for everyone, but for some, it might be a great way to speed up debt reduction before purchasing a home.
Buying a new home is one of life’s most exciting moments. It can also be one of the more stressful events you'll experience. Before getting started, it’s important to make sure you’re in the ideal position financially.
You don’t have to be completely debt-free. Lenders are looking to see if you can manage your finances, and if you’re responsible enough to pay back the loan. Waiting to conquer all debt may leave you farther behind financially.
Ready to move forward on your path to homeownership? Learn more about how to buy a house.
Sean Bryant is a Denver based freelance writer specializing in travel, credit cards, and personal finance. With more than 10 years of writing experience, his work has appeared in many of the industries’ top publications.
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