Should you pay off high interest debt first when getting a mortgage?

How you plan and budget your finances can have a big affect on whether or not you can qualify for a home loan. Following is what you should know if you’re trying to spruce up your financial picture for a mortgage…

Not all debt is created equal. For sound financial planning purposes eliminating the expenses in your life that contain the highest interest rates first is always a good approach. After all, why pay more interest right? When you apply for a mortgage, the paradigm shifts from high payment obligations to prioritizing the debts can improve your ability to borrow.

Know this…

  • Banks do not give any brownie points for you electing to eliminate high interest debt, but they will score you favorably by paying off debts with big payments.
  • Banks are not interested in the terms of your consumer debt obligations
  • Banks are covering themselves first as they are bearing all the risk.

Banks and mortgage companies do factor in what you are obligated to pay each month as a benchmark for a determining your credit capacity. This approach might not sound very logical to someone who has a large payment on a credit obligation with great low interest rate.

Here’s why: a mortgage is a loan against your income not the house, not your credit score, not your assets, but your income. The simple concept of income to offset a debt payment is what lenders look for among other things like credit, character, collateral and capacity, but income remains supreme. Gross monthly income less payments on current obligations (not what you choose to pay, but just the minimum amount owed) is how lenders will determine how much borrowing ability you have.

Here’s an example:

Car payment at $400 per month (0% interest rate) for a remaining balance of $10k

                                                                      VS

Credit card payment at $200 per month (16.99% APR) for a remaining balance of $5k

If you if you had an extra $5k to pay with, paying off the car would make more financial sense in buying a home even with a 0% APR. Your payment to income ratio drives how much house you can really buy. Lenders compute your payment to income ratio in the following way-sum of your total current payments + proposed total housing payment ÷ monthly income = debt ratio. Generally, with the exception of FHA Loans, this ratio figure cannot be more than 45% of your total income. In our car example above paying off the car loan would free up $400 per month in borrowing ability for a mortgage. This translates to about of 40K in home buying power, quite a large number indeed especially, if you’re in a competitive market.

Follow these steps when you decide to get pre-approved to buy a home:

  1. First and foremost pick reputable, experienced lender
  2. Identify which debts have the least balances containing the highest monthly payments
  3. Ask your lender to run scenarios including what you qualify for now with the obligations ‘as is’ and what you could qualify for if those liabilities were paid off. *Make sure those monies do not hurt the down payment or closing cost figures at your price points.
  4. Take heed in congratulating yourself on a job well done- your prudent budgeting may have just opened a door to a new neighborhood.

Each and every home buying situation is uniquely different. This information may or may not pertain to your specific situation. The whole concept is to cherry pick the obligations that pose the biggest threat to your home buying ability and pay them off in full if possible. By paying off high debt payment credit accounts you also demonstrate you can actually afford the home and subsequent payment you are applying for.

Looking to buy a home? Start with a free rate quote online now.

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