Buying Your First Home: Should You Save For a Down Payment or Pay Off Debt First?

Posted by Laine Smith on 10/16/16 10:54 AM

Topics: Conventional Loans FHA Loans Credit Score First Time Home Buyer USDA Loans Loan Types home buying Down Payments

Many potential homebuyers cite existing debt or saving funds for a down payment as the biggest hurdles in their homebuying journey. But what if you have existing debt and a low balance in your savings account? Where do you start?

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The truth is, it depends.

What You Need to Know About Down Payment Requirements

Contrary to popular belief, 20% down payment requirements are a thing of the past. Though a larger down payment may get you a lower interest rate and mortgage payment, the part where you actually have to save that money isn't a possibility for many first-time homebuyers.

Know your loan options and their down payment requirements before you determine your game plan of saving or paying down debt. Here are some low down payment loan options:

  • USDA Rural Development - No down payment required.
  • VA Loan - No down payment required.
  • FHA Loan - 3.5% down payment required.
  • Fannie Mae HomeReady - Down payment requirement as low as 3% for creditworthy, low to moderate income borrowers.
  • 1stHome Illinois - Offers $7,500 in down payment and/or closing cost assistance for for first-time homebuyers (or someone who has not owned a home in the last three years).
  • @HomeIllinois Mortgage - allows first-time and repeat homebuyers to buy a home with as little as $1,000 out of pocket.

Even if you are eligible for 100% financing, like the USDA Rural Development Loan, remember to factor in the costs of closing. Closing costs typically range anywhere from 2-5% of a home's purchase price, though you can talk to your lender about the possibility of a lender credit to offset your upfront costs.

Pros & Cons of Saving for a Down Payment

As mentioned previously, even if you're eligible for 100% financing, you'll still need some cash on hand for closing costs and possibly some items potential home purchase might need, such as furniture, appliances and home maintenance/improvement costs.

The negative side of saving for a down payment is the potential time it will actually take you to save that down payment percentage. While you're building your savings account, you'll likely still be paying a lofty rental price. Meanwhile, mortgage rates are still near historic lows. The best bet to determining whether saving for a down payment is the right approach for your homebuying circumstance is to know your loan options first.

What You Need to Know About Debt & Homebuying

Most lenders recommend that your mortgage payment, including principal, interest, taxes and mortgage 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 your monthly obligations such as: credit card minimum payments, student loans, alimony, child support, and car loans along with PITI. Lenders look at this to ideally be at or below 36 percent of your gross monthly income, though debt-to income ratio requirements vary among loan programs and lenders.

Pros & Cons of Paying Down Debt

Yes, you can buy a home with other debts but paying down credit cards can help you in two ways: by increasing your credit score and increasing your mortgage affordability.

Second to payment history, the amounts owed on your credit lines account for 30% of your FICO score. Typically, lower credit utilization ratios result in a higher FICO score. In turn, a higher credit score could get you better a better interest rate for certain loan types.

Paying down debt can also help increase your mortgage affordability. Remember the debt-to-income ratios we talked about? By paying down debt, you're freeing up some of your income to potentially spend on a larger home purchase. Most debt experts recommend keeping your balances below 30 percent of the credit limit for each card, with credit utilization below 10% being ideal.

If paying down debt is the route you take to prepare for mortgage approval, don't go all-out and close unused cards and old collections just yet. Closing unused cards can shorten your credit history and drop your score, while paying off old collection accounts brings those credit discrepancies to the present and also drops your score. Consult with your mortgage banker before doing either of those things during the loan process.

The best route to take for paying down debt is to focus on the debt with the higher interest rate first. Making larger-than-minimum payments on that credit card (while still paying at least the minimums on other bills, of course) is a good place to start.

Overall, the best way to determine how to get yourself in the best financial position to buy a home is to meet with a mortgage banker. Even if you know you aren't ready to buy, they can help you determine what amount of a down payment you should be saving for or how much debt you should be paying off to qualify.

Looking for more information about what it takes to buy and finance your first home? Download our free Mortgage 101 Handbook, a great resource for first-time homebuyers.

Download: Mortgage 101 Handbook

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