Should you pay off credit card debt before applying for a mortgage?

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Over half of U.S. adults (55 percent) owning credit cards say they also have debt, according to a 2019 CNBC Make It and Morning Consult survey. For people applying for a mortgage loan, credit card debt can pose a problem. If you don’t qualify for the lowest possible rate, you’ll owe thousands of extra dollars in interest over the life of the loan. You can also be denied a mortgage loan if your credit card balances are too high or your payment history lowers your credit score beneath the required threshold.

Should you pay off all credit card debt before getting a mortgage? In some cases, especially if your current credit score makes you ineligible for a mortgage loan, it’s a good idea to pay down credit card debt. But credit card debt isn’t the only factor in getting mortgage approval. There are several variables you need to consider if you carry debt and are looking to be approved.

What you need to know about mortgage loan approval

You don’t need excellent credit, but it helps

A home is one of the single biggest purchases the average American will make. With the median price of a home in the United States now $243,225, the interest rate you receive really matters.

For instance, the difference between a 3.5 percent and 4.0 percent rate means $56 dollars a month on a $200,000 mortgage. That $56 isn’t just money you get to keep in your wallet, either. The lower the interest rate is, the bigger the principal payments you’ll make each month. You are actually building equity faster when you have a lower interest rate.

When you look online, the low rates you see are “teaser rates,” typically only available to people with excellent credit (a score of 780 or above). It’s important to have a realistic sense of what your rate will be based on your current credit score.

Paying off your debt can raise your credit score, but it’s not always necessary to have an excellent score in order to end up with a competitive interest rate. If you have a good to very good score (at least 620) and qualify for a private mortgage loan (580 for an FHA loan), you can usually buy a “point” for an additional 1 percent of the loan value in order to reduce the interest rate from, say, 5 percent to 4 percent. Over the long haul, that could be a good investment.

Another option is to hold your mortgage for a few years, allow equity to build and then refinance to a lower rate. This can be a riskier strategy since mortgage rates could climb, the price of real estate could drop or both.

What about debt-to-income ratio?

Having credit card debt isn’t going to stop you from qualifying for a mortgage unless your monthly credit card payments are so high that your debt-to-income ratio is above what lenders allow. Banks and other mortgage lenders obtain your debt-to-Income (DTI) ratio by dividing your monthly debt by your gross (pre-tax) income.

There are actually two different DTI ratios that a mortgage lender may consider:

  • The front-end ratio divides your monthly household expenses, including the mortgage payment, by your gross income. You typically need to stay below 28 percent to be approved.
  • The back-end ratio takes your total debt payment into consideration, including your credit card payment. The figure you need to stay below is 36 percent.

Lenders generally consider the back-end DTI ratio more significant, and if it’s above 36 percent, you’ll have a hard time qualifying for a loan. Neither DTI ratio takes into consideration things like food and gas each month, and some don’t consider installment debt that is almost paid off.

Additional information

There are several ways to pay down credit card debt before you apply for a home mortgage loan, but some of them can affect your credit score in the short-term. For instance, if you get a new credit card with an introductory zero percent APR, you’ll see a slight hit to your credit just for having a hard inquiry on your account. This is something to keep in mind if you plan on applying for a mortgage loan within a few months.

Another way to pay off debt is to get a personal loan from friends or family members. Just remember that lenders calculate DTI based on your monthly payment amounts, not your credit card balance. Paying off some of a credit card loan won’t affect your DTI that much — though it could be just enough to put you below 36 percent.

Bottom line

Credit card debt is costly to own and should be the first thing you target in a debt-reduction strategy. But if you’d like to buy a house right away, it won’t necessarily be an impediment to loan approval 9provided that your DTI percentage is low enough and you have good to excellent credit).

Finding the top mortgage rates you qualify for is the first step to starting your journey. Once you own a home, you’ll be able to build equity and net worth, which can lead to even more debt-reduction options.