Should You Pay Off Debt or Save for a Down Payment?

Pros and Cons of Paying Off Debt First

Pros

• It can help your credit. If you have a lot of credit card debt, paying down your balances can reduce your credit utilization rate and, therefore, increase your credit score.
• It can reduce your debt-to-income ratio. If you can manage to pay off a credit card or loan in full, that'll remove the monthly payment from your debt-to-income ratio (DTI) calculation. Depending on your income and how much debt you have, this could help you qualify for a larger loan and give you a better shot at getting into the house you want.
• It may help you secure a better interest rate. The better your credit score and DTI, the higher your odds of getting approved with a lower interest rate. Depending on the size of the loan, a lower rate could save you thousands or even tens of thousands of dollars in the long run.

Cons

• Closing an account could temporarily decrease your credit score. Paying off a loan can have a temporary negative impact on your credit score, especially if you don't have a lot of other debt. A lower credit score could be the difference between approval and denial, and it can make it harder to secure a lower interest rate.
• You may not have enough for a down payment. While there are some home loan programs that don't require a down payment, you should generally expect to put down at least 3% to 5% on a conventional loan. Depending on the value of the home, your down payment fund may not be sufficient.
• You could pay for it in mortgage insurance. If you can manage a 20% down payment on a conventional home loan, you'll be able to avoid mortgage insurance, which can cost up to 2% of the loan balance every year. If a 20% down payment is a possibility, weigh the savings of paying off debt and the cost of ongoing mortgage insurance.

Pros and Cons of Saving for a Bigger Down Payment

Pros

• You could get a lower interest rate. The more money you put down, the less you'll have to borrow, making you less of a risk to the lender. As a result, higher down payments typically correlate with lower interest rates.
• You may be able to avoid mortgage insurance. Depending on how much mortgage insurance costs for your loan, you could save hundreds or even thousands of dollars every year if you can manage to save 20% of the home's value.
• You may be able to get into a home sooner. If paying down debt is making it impossible to save for a down payment, focusing on your savings could help you achieve the goal of homeownership more quickly.

Cons

• Your debt-to-income ratio may be too high. Depending on your income and debt payments, you may have too much debt to be able to get the home you want. Focusing on paying down debt could help you improve your situation in this regard.
• Your existing debt will continue to accrue interest. If you're not focusing on paying down debt faster, you may pay for it in interest charges on your outstanding balances.
• It won't help your credit. Although a larger down payment can make it easier to qualify for a lower interest rate, it won't help much if your credit scores are being dragged down by high debt.

5 Things to Consider When Choosing to Save or Pay Off Debt

As you try to decide whether to focus on your down payment fund or your debt, here are some factors to consider that can help you make the right decision for you:

1. Interest rates: If you have high-interest debt, paying it off could save you money in the short run compared to a slightly lower mortgage interest rate.
2. Credit score: If your credit score is in great shape, you can focus more on other factors in your decision-making process. If it needs work, though, paying down debt will give you a better chance of increasing your credit score.
3. Debt-to-income ratio: Your DTI is a crucial factor in the mortgage underwriting process, so if it's too high, a larger down payment may not be enough to save you. In this case, it may make sense to focus on your debt.
4. Debt balances: If you have loans with large balances, you may not be able to pay them off completely, which means your efforts wouldn't do much to help with your mortgage approval. But if your loan balances are relatively low, you may be able to easily pay them off completely.
5. Mortgage payment: Coming into a mortgage application with a lower DTI because you've paid off debt can help lower your interest rate, but it may result in mortgage insurance, which may neutralize the savings from the lower interest rate. In contrast, a higher down payment could help reduce your interest rate and potentially qualify you to get the mortgage insurance requirement waived.

Monitor Your Credit Before and During the Mortgage Process

Regardless of how you decide to proceed with paying off your debt or increasing your down payment, it's important to remember that your credit score is one of the biggest pieces of the underwriting puzzle.

If your credit score is relatively low, you may need to take other actions to improve it before you apply for a home loan. Review your credit score and credit report to identify areas where you can improve. And while you're going through the mortgage process, monitoring your credit can help you spot potential issues before they ruin your chances of homeownership.