Should I Save for a Down Payment on a House or Pay Off Debt?

When you’re preparing to buy a home, it’s important to get your finances in order. Not only will you have to be organized to fill out the loan application, but you want to otherwise streamline your finances to improve your chances of being approved for a loan and qualifying for a lower interest rate and a larger mortgage amount.

In fact, how much you have for a down payment is pivotal to this determination as is an assessment of your existing debt. But this creates a conundrum. If you have both a healthy down payment and a fair bit of debt already, what do you do? Do you pay off the debt and put up a smaller down payment, or do you keep both the debt and down payment intact?

The answer to that question isn’t difficult, but requires a close examination of your personal situation, such as how much of a down payment you can afford, how much debt you have, what interest rate it’s at, and how big of a mortgage you want to qualify for.

The Application Process

When you apply for a mortgage, the bank or broker will take into consideration the income you receive on a regular basis, as well as the debt payments you currently have. This will give them a picture of how much money you can spare each month to put toward a mortgage payment.

Based on this, your other assets, your credit history, and your down payment, the bank or broker will determine how large of a mortgage they can offer you and at what rate.

Case Study

Consider Jim, who is preparing to buy his first house. He has very good credit and takes home $36,000 per year after taxes. Jim also has credit card debt of $10,000, which has a minimum payment of $250 per month, but has no other debt. Jim saved up $20,000 to put towards his down payment and is looking for a 30-year fixed-rate mortgage. We’ll assume that home insurance costs $800 per year and property taxes are $2,000.

If Jim uses $10,000 of his down payment to pay off debt instead, he will qualify for a different mortgage amount than if he pays off no debt and puts the entire $20,000 down. Assuming Jim is able to qualify for a 6% interest rate, here’s how the numbers work out. Also, the consideration of private mortgage insurance, or PMI, does not significantly affect this comparison and is excluded for the sake of simplicity.

$20,000 down payment, $250 per month in credit card debt

$10,000 down payment, no debt

That’s a pretty big difference! Jim can qualify for a mortgage that’s $30,000 larger if he pays off his debt, even though his down payment is half the size. Why is the difference so large?

How the Loan Amount Is Determined

It has to do with how the bank calculates what you can afford to pay. Generally, the bank will take a percentage of your total monthly income (36% is common) and assume that is how much you can pay toward all your debt, including your mortgage.

In other words, your existing debt payments will directly reduce the amount the bank thinks you can pay towards your mortgage payment, homeowners insurance, taxes, and PMI, if required. Once they’ve determined how much of a monthly payment you can afford, they extrapolate how big of a mortgage for which you qualify.

Due to the nature of these calculations, the down payment only increases the total size of the mortgage you qualify for on a dollar-for-dollar basis. That is, if you qualify for a $150,000 mortgage and have an extra $10,000 to put down, you can qualify for a $160,000 mortgage. But since existing debt impacts how much the bank thinks you’re able to pay, it limits the size of your mortgage as well. In fact, paying off debt will increase the mortgage amount you qualify for by about three times more than simply saving the money for a down payment.

Thus, generally speaking, it makes the most sense to pay down existing debt if you want to max out your loan amount.

Additional Considerations

There’s another aspect to this consideration as well. The interest rate on credit card debt is often much higher than the interest rate on a mortgage, and it certainly holds true in Jim’s case. Moreover, you can deduct mortgage interest on your taxes, and thereby further reduce the rate you effectively pay on your home loan.

Since it’s almost always better to trade high-interest debt for low-interest debt, Jim’s decision from this perspective is a no-brainer. Not to mention that even if he puts the entire $20,000 down payment toward his home, he must still pay PMI, which is an added monthly expense if the down payment is less than 20%.

Read more here:http://www.moneycrashers.com/save-down-payment-pay-off-debt/