Should You Be Debt-Free Before Buying A Home?
Sean Bryant7-Minute Read
November 18, 2020
With mortgage rates at all-time lows, the cost of homeownership has never been better. This has many Americans thinking about purchasing a new home. However, if you’re a first-time homebuyer, there’s a lot you need to consider before taking this huge step.
For many households, debt is a common issue. This leads many to ask themselves, “Should I be paying off debt before getting a mortgage?” Unfortunately, the answer isn’t clear cut and it really depends on the individual situation.
When you apply for a mortgage, lenders are going to dig deep into your financial life. They want to make sure you’re going to be able to make payments on your loan each month. Your current debt levels are a key indicator for them. However, your ability to manage your debt effectively is what’s really important. Managing debt has a direct tie to your credit score, which is a big factor in whether you’re approved for a loan and what your rate will be.
So should you be debt-free before buying a home? While it’s probably a good idea for some people, it’s not necessary for everyone. Let’s dig a little deeper to determine the best path for you to take.
Common Sources Of Debt For Home Buyers
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.
- Credit card debt: According to a Wallethub study, the average household credit card debt in the United States was $7,938 in the second quarter of 2020. 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.
- Student loans: The student loan debt crisis has been well documents during recent years. The costs to attend a 4-year university, public or private, has steadily risen over the past decade. While the Coronavirus 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%.
- Auto loans: Another big source of debt for Americans is auto loans. More than 85% of new vehicles purchased are done so with an auto loan. Used car purchases are more frequently made with cash but just over 55% is still financed. Similar to student loans, auto loans tend to have more favorable rates as compared to credit cards. The average interest rate for a new car in 2020 is 5.61% and 9.65% for used cars. However, borrowers with good credit have loans available for less than 4%.
Pros And Cons Of Paying Off Debt Before Applying For A Mortgage
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.
Higher credit scores: 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 exactly how credit utilization works. Let’s assume you have a total credit limit of $10,000 between two credit cards and you have 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.
Lower your debt-to-income ratio: One factor in determining how much a lender is willing to lend for a mortgage is your debt-to-income ratio. 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.
Available cash for a down 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.
Financial Factors That Impact Your Ability To Get A Mortgage
Debt-To-Income (DTI) Ratio
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.
Type Of Loan
Unless you’ve already done a lot of research, you might not know that there are many different types of mortgage 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.
Tips For Managing Your Debt Before Buying A House
When deciding whether you want to pay off your debt before purchasing a house, there are both advantages and disadvantages. But even if you choose 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.
Focus On Credit Repair
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.
Consolidate Your Debt
If you’re paying off many different types of debt, whether that includes student loans, multiple credit cards, and maybe a car loan, it might make sense to consolidate your debt. This could potentially help you lower your interest rate, but it will 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.
Refinance Interest Rates
If you determine that consolidating 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’ll 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.
The Bottom Line
Buying a new home is one of life’s exciting moments. It can also be one of the more stressful events you’ll experience. Before getting started, make sure you’re in the ideal position financially. While it’s not necessary to be debt-free before taking out a mortgage, it does need to work for you. Make sure your debt-to-income ratio is low enough so that you won’t be stretching yourself too thin with another debt payment. Also, check that your credit score is in a good spot since this will affect your interest rate and how much the loan will cost. Once you’re in a place your comfortable with, enjoy the process and your new home.
For even more help with the home buying process make sure you check out all the other articles on the Rocket HomesSM blog.
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