|Q: I would like to purchase my first home in 6 months. A loan officer pulled my credit report a few months ago and I've almost paid off my bills. I have about another $4,000 in balances left on four accounts. Should I pay off my debt before buying a house?|
A: The answer always depends on several factors, but as a general rule - no. If you're looking to purchase a house soon, like the reader above, then you need cash for down payment (unless you're looking at a zero down program), closing costs and then reserves.
The down payment can range from 1 percent up. In the above example, the $4,000 could go a long way toward closing. But if you spend all your extra cash to pay off that amount, then you are at ground zero again and have to start saving up for the above mentioned expenses.
Besides, the traditional debt-to-income ratio calculation allows buyers to have consumer debt when qualifying for the loan. The standard debt ratio is 28/36 - 28 percent of your income can be used for your mortgage payment, which includes taxes and insurance; and 36 percent for the mortgage payment plus the rest of your debt.
For example. A person who wants to purchase a $200,000 property with a 10 percent down payment must qualify for a $180,000 loan. At 7 percent on a 30-year fixed rate, the estimated PITI would be about $1,400 per month (depending on your local property tax rate). That payment is 28 percent of $5,000, which means our buyer would have to make $60,000 annually to qualify for the above described loan.
In addition, the borrower can have another 8 percent in debt - bringing his or her total debt payments to $1,800 per month. As you can see, if you pay off a loan balance for $4,000, but it only gives you another $75 - $100 in monthly cash flow, it's not going to positively effect your buying power. It just eats up the cash you would have had without paying off the debt.
Granted, there are some loan programs that allow higher ratios, but you are more than likely going to pay higher interest rates and points to use that type program.
Keep in mind, I adhere to the G.O.O.D. principle - Get Out Of Debt - just as a matter of smart money management. But it's not always the best move to pay off all your debt while you're trying to save money for the purchase of your house. Owning a home is always a lot better than renting and if paying off your consumer debt first keeps you out of the housing market, then you're really losing money by paying rent instead of building wealth and taking advantage of tax benefits through homeownership.
This is especially true if you live in an area that is experiencing good appreciation in home values. If nothing else, you can refinance your house in a few months or years and pay off the debt with cash from your equity. This way, the interest now being used to pay off the credit card balances is tax deductible, because it is part of your house payment.
If the $200,000 property above is appreciating at 5 percent (just below last year's national average of 5.5 percent, according to the National Association of Realtors), then in one year, that house will be worth $210,000. The next year it will be worth $220,500 - which gives you more than $40,000 of equity to dip into to pay off consumer debt if you want to. (The $40,000 comes from subtracting your loan amount - $180,000 - from the current value of your house - $220,500.) With a bit of patience and budgeting, you've now started building wealth by leveraging your money. The $20,000 down payment has more than doubled, you now have equity to pay off debt and you're taking home more of your paycheck because you can deduct all that interest each year from your income, thus lowering your tax bill.