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Pay Off Debt Before Buying a House?

If you’re looking to buy a home and you have other outstanding unsecured debt, we have some comforting news: You don’t have to pay down all of your existing debt before financing a new home. But there is one crucial mortgage metric you can’t escape: your debt-to-income (DTI) ratio.

What is this, and why do lenders care?

It’s All About DTI Ratio

Among the many salient factors lenders review when considering your home-loan application is your debt-to-income ratio. This scale identifies how much of your monthly pre-tax income is required to service your existing debt. Considering all of your debt – from student loans to credit cards to auto loans, plus a new mortgage payment, it’s easy to calculate your DTI ratio.

If, for example, your gross monthly income is $5,000:

  • Pre-tax income = $5,000
  • Expenses: student loans ($400), car loan ($200), personal loan ($200), new mortgage payment ($1,500), for a total of $2,300
  • $2,300 debt ÷ $5,000 income = 46% DTI ratio

Lenders use your DTI ratio to ensure that you’ll have enough income after paying your other monthly expenses, to cover your mortgage payments. It makes sense, then, that a higher DTI ratio suggests that you are more likely to struggle with repayment of your mortgage – and your total debt.

So, don’t panic if you’re shouldering a bit of debt, as long as your DTI ratio is comfortable. If your DTI ratio pushes you into a higher risk category, you might still be able to secure a mortgage, but you might not get as much money as you want, and your interest rates will be higher.

Remember: Debt that outstrips a sensible proportion of monthly income is the primary reason that lenders reject mortgage applications. The precise acceptable DTI ratio varies from lender to lender. As a guideline, you should aim for a ratio somewhere between 35 percent and 50 percent.

But what if you are struggling under more debt than that? What can you do to fight back?

Two Ways To Improve Your DTI

If you’ve taken more debt than your home lender is comfortable with, consider one of these two options for skewing your DTI ratio back in your favor:

  1. Consolidate your debt
  2. Pay off your debt in full

Consolidate Your Debt

The object of debt consolidation is to use a single loan or credit card to combine your debt into a single account. You can bring together installment debt, including personal loans, with revolving debt of multiple credit cards, to make a single payment with a single interest rate to a single lender, potentially reducing your total monthly expenses.

Perhaps the most common way to consolidate debt is to take out a dedicated installment loan. You’ll have a predetermined timeframe in which to pay off the loan, and you’ll make monthly or biweekly payments to a single entity.

If your finances are squeezed tight and you can’t make any meaningful reductions, extending your repayment term might cost you more over time, but it will bring down your DTI ratio.

Pay off Your Debt in Full

Have you got any surplus cash on hand or in savings? If so, you might benefit from paying off your debt if you’re trying to qualify for a mortgage, thus bringing down your DTI ratio.

One trick to keep in mind is that credit scoring companies view open accounts more favorably because they are indicative that you manager your credit responsibly. So, don’t close your credit accounts, just pay them down.

The Bottom Line

Everyone’s circumstances are unique, so there’s no boilerplate answer to the question, “Should I pay off debt before buying a house?” It’s all about keeping your debt-to-income ratio healthy, even if that means reshuffling or paying down some debt before applying for a home loan.

Writer

Vivaan Marsh is a professional writer, editor and an expert in personal finance. Her career as a professional writer stretch for over 11 years. One of her passions in life is to help everyday families with there financial problems, making their life a bit easier and explaining complicated topics in an easy way. Read more >

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