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Dr. Don Taylor, CFA, advice columnistDeciding 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.

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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."'s corrections policy -- Posted: Oct. 20, 2006
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