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Ask Dr. Don
By
Don
Taylor,
Ph.D.,
CFA
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Bankrate.com |
Down payment or loan prepayment?
Dear Dr. Don,
I have about $8,000 left from a five-year car loan at about 8 percent.
Should I use money from my money market savings account to pay off
this car loan or keep making my monthly payments?
I am getting ready to buy a house and would like to
know if it would be better to save that money and put it toward
my down payment on a house.
Thanks,
Chris Choice
Dear Chris,
It depends on what problem you're trying to solve. Can you qualify
for the loan you need to buy the home you want without paying off
the car loan?
Mortgage qualifying ratios in general limit your mortgage
payment to no more than 28 percent of your total gross income and
all your debts to no more that 36 percent of your total gross income.
Car payments and credit card debt can easily exceed the 8 percent
of total income debt limits, restricting the size of the loan.
The benefit to paying off the auto loan is that it
frees up some loan capacity. You may be able to qualify for a larger
loan with fewer outstanding debts.
Use Bankrate's How
much house can you afford? calculator to estimate the loan payment
and loan size that you'll qualify for under different scenarios.
One reason to not pay off the car loan and instead
use the money to make a larger down payment is because the larger
down payment may either help you avoid private mortgage insurance
(PMI) or reduce the amount of your PMI payment and shorten the amount
of time you need a PMI policy. Use this PMI
calculator to estimate the monthly cost of the insurance.
There are alternatives to paying PMI, but they involve
in one way or another paying higher interest rates on your mortgage.
You could use an 80-10-10
mortgage where you put 10 percent down and borrow 10 percent
as a second mortgage. Alternately, you could borrow using a self-insured
mortgage that doesn't require PMI but carries a higher interest
rate to compensate the lender for the additional risk.
Don't forget to consider your overall financial
picture. It's pretty hard to tap the equity in your used car without
taking the bus everywhere. Accessing the equity in your home is
a simpler matter. If you're spending down your emergency-fund savings,
it makes more sense to use it toward a down payment than it does
to pay off your car loan.
-- Posted: April 9, 2002
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