Frequently Asked Question: For a Mortgage, Is it Better to Save for the Down Payment or Pay Off Debt?
Q: What is better in the eyes of the lender - to have a smaller down payment or have less debt? I cleaned out the money I had saved for a down payment and paid down some debt, but what should I do going forward?
A: That depends. Having more money available for the down payment won't necessarily qualify you for more house. However, using available funds to pay down your debt might.
Your overall monthly debt payment is one of the factors lenders use to determine your mortgage qualification. It can also affect your credit score. By paying down your debt, it may help improve your credit scores which will allow you to qualify for better mortgage interest rates. It will also reduce your overall monthly debt obligation and may allow you to buy a more expensive house.
Lenders use two debt-to-income ratios to determine your eligibility for a mortgage amount. The first is the "housing expense" or "front-end ratio." This is the proposed monthly mortgage payment which includes principal and interest, 1/12th of your annual property taxes and homeowner's insurance premiums, and monthly mortgage insurance premiums and homeowner's association dues, if any. The "total expense" or "back-end ratio" includes the monthly housing payment or "front-end ratio" and all other monthly debt obligations.
For each loan program, lenders set a maximum debt-to-income ratio for housing and total debt. Typically, the front-end ratio can not exceed 28% of your gross monthly income, and the back-end ratio can not exceed 36%. However, many loan programs allow as much as 31% on the front end, and 41% on the back end. The back end can be as high as 45% if you have compensating factors such as good credit and a sizeable cash reserve.
If your back-end ratio is high (too much debt), it will reduce the amount of mortgage you can qualify for - and reduce the how much house you can buy.
If you don't have enough money saved for a 20% down payment, then you may be well off to apply for an FHA mortgage or a USDA Rural Development Loan. With FHA, you can put as little as 3.5% down, while you can buy a home with no money down with USDA. Another plus with USDA is there is no monthly mortgage insurance premiums.
There are limiting factors with FHA and USDA loans. With FHA, the maximum loan amount is based on the county the home is located in. You can check the FHA mortgage limits at https://entp.hud.gov/idapp/html/hicostlook.cfm.
With USDA, the home must be located in a rural area (typically a town with a population of 10,000 or less). You can check the address of a home you want to buy to see if it will qualify. And, your household income can not exceed the maximum for the area. You can check the USDA Income and Property Eligibility Site at http://eligibility.sc.egov.usda.gov/eligibility/welcomeAction.do.
It's best to consult with an experience mortgage consultant to help you determine the how best to pay down debt to enable you to buy the home of your dreams.
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