Should Debt Be Paid Off Before Buying a Home

Things to know about debt and buying a home

Thinking of purchasing your own home? There are several factors to weigh, especially if you're a first-time mortgage applicant carrying debt. While having debt isn't necessarily a deal-breaker, it can influence how much you can borrow, the interest rates, and other loan terms.

Understanding the home loan process is crucial in deciding whether to prioritize paying off debt or saving for a down payment and an FHA loan is different than a conventional loan. There are greater benefits to dealing with debit for an FHA loan, and here's what you should know:

1. Know Your Debt-to-Income Ratio

Lenders use the debt-to-income ratio (DTI) to assess whether borrowers can manage mortgage payments alongside existing debt. DTI is calculated by dividing monthly debt payments (including future mortgage, credit cards, loans) by gross monthly income. Generally, lenders prefer DTI to be below 43% of gross earnings. However, FHA loans have a max DTI of 56.99%, meaning there is a bit more flexibility in regards to how you can manage your debt.

For example, if a couple pays $600 for auto loans, $240 for a student loan, $200 for credit card debt, and plans a $2,000 mortgage payment, with a combined gross monthly income of $8,000, their DTI ratio would be 38%.

2. Understand How Debt Impacts Your Credit Score

While a mediocre credit score might not hinder your mortgage eligibility, it plays a significant role. Factors such as employment history and income are considered, but credit score and credit report information are crucial in determining loan qualification and interest rates.

Typically, a FICO® Score of 620 is sufficient for a conventional mortgage, but lower scores might qualify for FHA or VA loans starting at a credit score of 500. However, the higher the score, the more loan options you're likely to have.

Payment history and credit usage significantly impact credit scores. Lenders prefer a credit utilization rate under 30%. However, paying off all credit card debt before buying a house isn't always necessary. Responsible management of debt and consistent, timely payments can maintain a good credit score. Abrupt changes in credit behavior during the loan process could raise concerns for mortgage underwriters.

3. Make Sure You Have Enough For A Down Payment

When deciding to pay off longstanding debt or not, besides how your DTI and credit score could be affected, you also need to be sure you have enough saved for a down payment. An FHA loan offers borrowers a great benefit of only having to put a 3.5% down payment at the time of purchase for credit scores of 580 and above. If your credit score is between 500 and 579, the minimum down payment will be 10%. You will also need to factor in closing costs that can be a few percentage points of the purchase price of the home. Because an FHA loan does have some flexibility with your DTI, it would be wise to first consult with a loan officer to understand what is necessary to get pre-approved for a home loan. This will help you with planning for your purchase.

4. Other Steps

HomeLoanGurus specializes in assisting first time home buyers and borrowers with lower credit scores get into a position to purchase a home. We can connect with a loan officer to get started on your pre-approval, and we can also help you get into a better credit position as well. HomeLoanGurus is a data furnisher and if you are a renter, we can potentially help you improve your credit score by reporting your rent payments to the credit bureaus. To learn more about rent reporting, take a look here.

Conclusion

When preparing to buy a home, assess your debt, understand your credit score, and maintain consistency in your financial behavior. While debt isn't necessarily prohibitive, managing it responsibly and understanding its impact on loan eligibility is crucial in the home buying process. HomeLoanGurus works with lenders that specialize in FHA loans for borrowers with credit scores starting at 500. Your debt-to-income ration (DTI) would be something to discuss with a mortgage professional to see if you need to pay down credit cards, etc. If you are ready to speak with a loan officer now and learn more about your qualifications, please submit your information here.