 Deciding
between debt and down payment
|
 Dear
Dr. Don,
My wife and I recently moved in with my parents to save money for a house. We have around six or eight months to do this. However, we have around $4,600 in credit card debt that we would like to get paid off.
Is it smarter for us to pay off the credit cards first
and then save money, or split the money between paying down the
cards and savings? I am worried that if we pay off the cards first,
we will not be able to save enough money for the home purchase.
-- Adam Accumulate
 Dear
Adam,
I lean toward building up a war chest for a down payment and closing
costs over focusing on paying down the credit cards. It will have
a greater impact on how much house you can afford. Try using Bankrate's
home affordability calculator
to run two scenarios, one where you have the credit card debt paid
off, but have $4,600 less for a down payment, and one where you
still have the credit card debt but have $4,600 more for a down
payment.
Lenders calculate how much of your monthly income
is going to PITI: principal, interest, taxes and insurance. That
number is called the front ratio, and lenders normally require that
your front ratio not be higher than 28 percent. They'll also calculate
a back ratio, which looks at housing expenses plus all your other
contractual payments, including credit card debt, to determine what
percentage of your monthly income is committed to these debts. Lenders
historically have looked for a back ratio of 36 percent or less.
Increasing the down payment reduces the loan amount,
which reduces the front ratio. Paying off the credit cards reduces
your outstanding debt, which reduces the back ratio. Conventional
mortgage loans are fairly strict with these measures, while FHA
and VA loans are more flexible. A nonconforming loan, meaning a
loan that doesn't meet conventional underwriting standards, is also
more flexible on these ratios and in some cases may only look at
the back ratio.
I think these ratios make sense in all but the most
expensive real estate markets. If roughly one-third of your income
is going toward paying off debt and roughly one-third of your income
goes toward taxes (federal/state/local), then you only have one-third
of your income to cover other living expenses and to invest for
your future. The government is pretty inflexible about getting its
share, so don't go so deep into debt that you don't have the financial
flexibility to manage both your current expenses and save for the
future.
To ask a question of Dr. Don, go to the "Ask
the Experts" page and select one of these topics: "financing
a home," "saving & investing" or "money."
|
