Is it Better to Pay Off Debt or Save for a Down Payment?

Are you renting a home right now, but want to buy your own home? If you are in debt, you might wonder what you should do with your savings. Should you pay down the debt or save for a down payment?

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Both issues are important. You need a down payment to buy a house. But, if you have too much debt, your debt ratio might be too high and you won’t get a loan approval. So what should you do?

Look at Your Situation

There isn’t a cut and dry answer regarding how you should proceed. While you need a down payment, you may not need an ‘excessive’ down payment. It’s also nice not to have any debts going into a new mortgage, but if the payments are low enough, it may not affect your loan approval very much.

So you have to look at your situation. Ask yourself:

  • Do I have money to put down on the home? You are going to need some type of down payment unless you qualify for VA or USDA financing. At a minimum, figure you will need 3.5% of the home’s price to put down on a home (that’s the FHA requirement).
  • Do I have money for closing costs? Don’t forget, it will cost you money to borrow money. You’ll need between 3% and 5% of the loan amount to cover the closing costs. Some lenders do offer a no closing cost loan, but you’ll pay a higher interest rate, making the payment higher.
  • Do my current debts take up too much of my income? Your lender will calculate your debt ratio based on your gross income (not your take home pay) and your minimum monthly payments as reported on your credit report. If your debts take up more than 36% of your gross income, there’s no room for a mortgage payment.
  • Can you decrease your monthly payments? If you have a way of transferring your debts to a zero interest credit card or you can refinance the debt with a lower interest rate, it may lower your debt ratio. This may make it possible to keep the debts and put the money down on the home instead.
  • Do you have an emergency fund? Once you own a home, you must have an emergency fund. This fund should have between three and six months of income in it. This will help you in the face of an emergency at your home. You can avoid financial destruction and pay for the emergency in cash.

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Once you answer these questions, you will have a better idea how you should proceed.

Making the Down Payment

It may make sense to make the larger down payment if all of the following are true:

  • You don’t have any debt
  • You have some debt, but the minimum payments fit within your budget and debt ratio.
  • You have an emergency fund set up already.
  • You have extra money for closing costs.

Making the down payment will lower your mortgage payment because you’ll need to borrow less. Of course, this only works if you keep the purchase price of the home the same and put money towards it rather than increasing the price of the home because you have a larger down payment.

Paying the Debts

Sometimes it makes sense to pay the debts off instead. This is the case if the following are true:

  • Your minimum payments are high, which causes your debt ratio to be too high for mortgage approval.
  • You have enough money to put down on the home. In other words, you meet the minimum down payment requirements for the program.
  • You only have enough money for the closing costs.
  • You can’t decrease your minimum payments by transferring the debt or refinancing it.

Additionally, you should ask yourself what interest rate you are paying on your debt. Is the interest so high that it costs you an arm and a leg to have this debt? No matter your situation, it may make sense to just pay this debt down or off completely so that you can stop paying excessive fees for it.

It’s all about finding the happy medium. You may have to pay some debts down and put the rest of the money down on the home. You also may not have to touch your debts because the minimum payments and the interest are manageable.

The best thing you can do is take a look at the big picture. Will you gain anything by making a larger down payment? For instance, will the lender give you a lower interest rate or impose lower closing costs? Will you be able to afford a more expensive home that was really what you wanted in the first place? With these answers, you can figure out the best way to proceed with your money and your new home.

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