While you don't need to be debt-free to purchase a home, a mortgage is a big financial commitment, so many homebuyers choose to lighten the load of their existing debt when preparing to buy a house. Though existing debt may not be a homebuying hurdle for everyone, financial freedom is a heavily sought goal for many.
One out of every 3 households carries credit card debt from month to month, according to data from the 2015 Consumer Financial Literacy Survey by the National Foundation for Credit Counseling. Here are several tips to help you get those balances lower in order to improve your chances of loan eligibility and increase your mortgage affordability.
1. First things first. Make a budget.
It's impossible to scale back on spending when you don't know exactly where your money is going. Make a monthly budget that includes your inflow and outflow, then determine where you can cut costs to go toward existing debt.
2. Envision your debt pay-down finish line.
When it feels like you're drowning it credit card and loan payments, it's hard to see the light at the end of the debt-free tunnel. If you know you want to pay down debt before buying a house, determine how much debt you want to pay down first. If you need to pay down debt to increase your mortgage affordability and achieve loan eligibility, talking to a mortgage banker is the best way to determine the necessary goals when decreasing debt to buy a home.
Most lenders recommend that your mortgage payment, including principal, interest, taxes and insurance (known as PITI), be less than 28 percent of your gross monthly income. Lenders will also analyze your debt-to-income ratio, which includes monthly obligations, such as credit card payments, student loans, car loans, alimony, child support, along with your PITI. Lenders ideally want this ratio to be at or below 36 percent off your gross monthly income.
3. Determine what repayment strategy will give you the most motivation.
Do you want to pay down your debt in the fastest amount of time and save more money or do you want to see immediate gains along the way to stay motivated?
The two most common debt pay-down strategies are:
- Debt snowball - You pay off the smallest debts first, giving you immediate gratification.
- Debt avalanche - You focus on paying off debts with the highest interest rate and work your way down, cutting more interest costs along the way.
4. Remove the temptation.
Paying down debt also requires not accumulating any more of it which is hard when your credit cards are readily available in your wallet. Leave them at home when you go shopping, even if you're enticed by your cashback rewards or miles. If you can't pay for it in cash, you shouldn't be buying it.
If you're an online shopper, it's also a good idea to delete your credit card information from your accounts so you'll be less likely to use a credit card when checking out.
But don't make the mistake of canceling you cards right now if you're planning to buy a home. Closing a card increases your credit utilization if you have existing balances and could shorten your credit history, therefore dropping your credit score.
5. Become a cash-only consumer.
Making a budget only goes so far if you don't take the initiative to follow it, which is especially hard when most consumers pay for groceries, entertainment, clothing, etc. with debit cards.
After making your budget, consider using the "envelope method" to divide your cash funds in envelopes to cover monthly expenses like groceries, clothing, gas and entertainment. If you put $100 in your "entertainment" envelope and go out to eat and to a movie, when it's gone, it's gone. Don't use your debit card or go to the ATM for a cash withdrawal.
While using your debit card doesn't directly contribute to debt, there is some psychological connection that makes swiping a card seem like less of an expense than paying in cash.6. Be wary of balance transfers.
If you have a high-interest card with a balance, it can be a smart move to place that balance on a card that offers a zero-interest balance transfer. Just be sure you can adhere to the terms of the balance transfer, which usually includes paying off that transferred debt in a certain amount of time. Otherwise, you'll likely be hit with a substantial interest charge.
7. Look at your savings plans versus your debt accumulation.
If you're preparing to buy a house, you're probably also considering saving for a down payment. A common question for first-time homebuyers is whether they should pay down existing debt or save for a down payment. The answer isn't exactly straightforward for every borrower, but if you have a nest egg built up, you can consider using that towards your existing debt if it makes financial sense.
Look at the rate in which your savings account grows versus the rate at which your interest rates pile up. If you're racking up more in credit card interest than you're making in your savings, it may be a good idea to distribute at least some of that money into your existing debts.
8. Reward yourself when you reach milestones.
Don't view paying down debt as a source of punishment. Give yourself a small reward when you reach a goal, i.e. paying off a credit card.
As mentioned before, the best way to know how your existing debt coincides with your homeownership goals is to meet with one of our mortgage bankers.
For more information about buying and financing a home, download our free Mortgage 101 Handbook for everything you need to know about the homebuying journey.