Buying a home can feel like a complicated process—especially when you’re trying to secure financing. As you start thinking about a mortgage, you’ll probably have several questions about your financial situation, including, “Should I pay off debt before buying a house?”
We’ll dive into the details of a key mortgage metric—your debt-to-income ratio—and discuss whether you may benefit from paying off debt. We’ll also cover two different ways to pay down debt.
Debt-to-income ratio: An important mortgage metric
First, let’s be clear that you absolutely can finance a home while having other debt. Lenders don’t require that you have zero debt to qualify for a home loan. What lenders do care about is your debt-to-income (DTI) ratio: How much of your monthly pre-tax income is dedicated to paying debt, like student loans, credit card bills, auto loans and the new mortgage?
Here’s an example: Say your monthly gross income is $4,000. If you have a monthly car payment of $200, student loan payment of $300, and personal loan payment of $100, adding a mortgage payment of $1,500 would make your DTI ratio 52.5% ($2,100 in monthly obligations ÷ $4,000 in monthly income).
Lenders care about your DTI ratio because they want to make sure you have enough available income to cover your existing debts plus the mortgage. In other words, they are trying to determine your ability to repay the loan. The more debt you have, the higher the statistical risk that you’ll fall behind on your payments. Borrowers with lower DTI ratios and better credit scores are typically considered by lenders to be less risky, so they are generally offered loans with better terms, like a lower interest rate or higher loan amount.
In fact, too much debt relative to monthly income is the top reason mortgage applicants are rejected, according to The Washington Post. How much debt is too much? It depends on the lender; the maximum is generally in the 36-50% range.
Improving your debt-to-income ratio
If you want to improve your DTI ratio and possibly qualify for a mortgage with more attractive terms, you can earn more income or reduce your monthly debt load. Let’s discuss two ways you can reduce your debt.
1. Pay off debt outright
If you have cash on hand to immediately pay off the outstanding balance of an existing loan, your DTI ratio would decline. Returning to the example above, if you eliminated your monthly car payment, your new DTI ratio would be 47.5% ($1,900 in monthly obligations ÷ $4,000 in monthly income), which could mean you’ve become eligible for a mortgage that was previously out of reach.
Keep in mind, however, that paying off the loan early might impact your credit score. Credit scoring companies like Experian score open and active accounts more highly than closed accounts “because they demonstrate that you’re managing credit well now and not just in the past.”
2. Consolidate debt to reduce monthly payments
Debt consolidation generally means using one loan, credit card or service to pay off multiple loans, which can include revolving debt like credit cards or installment debt like personal loans. Instead of making payments to multiple creditors each month, you’ll make one payment to one entity. Debt consolidation can potentially lower your interest rate and reduce your monthly payment—which would lower your DTI ratio.
One of the more common ways to consolidate debt is with a debt consolidation loan.
This type of installment loan allows you to consolidate multiple debts, including credit cards, medical bills and other types of loans. Installment loans have a set payoff date and let you make monthly or biweekly payments.
After you’re approved for the loan, the lender will either pay off your existing debts for you or disburse cash to you to pay off debtors yourself. After that, you’ll make one loan payment at the new rate.
Let’s say you were able to consolidate your student loan and personal loan into one loan with a lower monthly payment of $190. You’re still making the $200 car payment and adding in the $1,500 mortgage with $4,000 in monthly income. Your new DTI ratio would be 47.25% ($1,890 in monthly obligations ÷ $4,000 in monthly income).
Some borrowers choose a longer repayment term for their debt consolidation loan. While this may reduce the amount of your monthly payment—and reduce your DTI ratio—you might end up paying more interest over the life of the loan than you would have originally.
In conclusion, the answer to, “Should I pay off debt before buying a house?” depends on your unique financial situation. Understanding your DTI ratio and what you can do to lower it can help you make an informed decision.
With RISE, you borrow what you need, when you need it. Apply for an online installment loan with RISE today.