It’s a very common question when someone starts to shop for housing: “Should I pay off my debt to qualify for a mortgage?”
It seems like a yes-or-no question, but unfortunately the answer is fairly complex and involves many different factors. While paying off debt, or at the very least, lowering it, has undoubtable benefits, if quickly securing the best possible mortgage payment is the top priority, paying off your debts may not be ideal. In other situations, however, significantly reducing or eliminating your debt could be the perfect route.
So the answer to the question really is…“maybe.”
Paying Off Debts to Qualify for a Mortgage
Installment Debts Compared to Revolving Debt
To understand whether or not you should pay off your debt, you need to look at your debt load as a whole and understand what type of debts you have. You should be especially diligent to separate your obligations by “installment debt” and “revolving debt.”
What is Installment Debt?
Anything that you pay on a set schedule for a determined period of time is considered installment debt or “installment loans.” If you pay $400 a month for the next five years, it’s an installment loan. This category of debt generally includes home loans, auto loans, student loans, and business loans. Auto leases, however, are not considered installment loans, because it’s not really debt in the traditional sense; you didn’t actually borrow money. Rather, leases are more like cable bills, in that you pay a monthly fee for a specific service, which in this case is the use of a car.
If an installment loan is co-signed by another person, you may be able to exclude it from your total debt load, assuming you can provide proof that someone else is making the payments.
What is Revolving Debt?
Revolving debts are essentially items that are not on a set schedule like monthly or weekly payments. Credit cards are likely the biggest form or revolving debt, as you can borrow and pay off the debt as needed. Lines of credit that you can draw from when you want, such as a HELOC, are also considered revolving debt.
Revolving debt cannot be excluded from your debt-to-income ratio even when they are paid off. This is because the revolving debt is simply too easy and convenient to run up after a mortgage loan is written. For example, someone could have $5,000 of revolving debt on a credit card, but they pay it off before looking for a mortgage loan to reduce their DTI. Once the loan is made, they could go out and rack up another $5,000 worth of credit card debt on new furniture, which could increase their chances of defaulting on the mortgage.
However, if the revolving loans are paid off and closed, it can help reduce your debt load because you no longer have access to that line of credit. This makes lenders more comfortable, so they will agree to remove it from your DTI. Unfortunately, closing credit cards can lower your credit score. (See “Disadvantages” below.)
Benefits of Paying Off Debt
The top reason to pay off or reduce your overall debt is to decrease your debt-to-income ratio. DTI is a mathematical formula that calculates the amount you owe compared to the amount you earn. If, for example, you earn $8,000 a month and have $2,000 in monthly debt payments, you DTI will be 25%. This is an important number for lenders, as it gives them a rough estimate of your overall ability to take on more loans. Generally speaking, the lower your DTI, the better. So if Borrower A has a DTI of 30%, and Borrower B has a DTI of 45%, Borrower A is more likely to qualify for a mortgage loan. (Assuming all other factors are the same.)
Therefore, if you can eliminate a significant portion of your debt, you can quickly reduce your DTI and increase chances of approval. Let’s say you have a $500 monthly bill for a car loan that has a total remaining balance of $8,000. You earn $10,000 a month, but have $4,500 in monthly debts, for a DTI of 45%. By paying off the car loan (assuming you have the cash, of course), you reduce your monthly debts to $4,000, giving you a DTI of 40%.
The FHA, for example, requires a 43% or lower DTI, so in the above example, it would make a difference in the approval, assuming there are no income restrictions for whatever program you are using. (The above example used an annual income of $120,000, which could disqualify you for some programs.)
Disadvantages to Paying Off Debt for Mortgage Qualification?
While being debt free is certainly relieving, don’t rush out and pay off all your debts just yet. First, consider a few of these potential disadvantages…
One of the major problems with paying off debt is that is takes away from your potential down payment. Say you spend $20,000 to get rid of all your debt. Now you may not have enough to pay for even a small down payment. Depending on how much money you have on hand and how large a down payment you want to offer, it may be wise to keep the money, or at least some of the money. This is especially true if you are on the verge of having a down payment large enough to eliminate mortgage insurance, which usually disappears once you reach 20% equity.
It’s also possible that closing credit accounts will reduce your debt-to-credit-limit ratio. This is basically a formula that looks at the amount of debt you have compared to the amount you could have. Closing accounts reduces the amount you could have, which means, if your debt stays the same, you are using a higher percentage of the available credit. This could potentially cause a drop in your credit score.
Complete Advice for Your Homeownership Future!
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