Pay Down Debt Or Save For A Downpayment?

My friend has been diligently working to get her finances back in order after a bankruptcy, divorce and relocation. In the last year, she has secured a new job with a double-digit salary increase and has been saving as much as she can at her local community bank which she hopes will finance the house she wants to buy. Unfortunately, she recently had to replace her older car, and even though she bought used, it still cost just over $20,000 all-in.

Now she is dividing her excess cash flow among: 1) a car payment at 16% (the bankruptcy!); 2) a $3,000 credit card balance at an even higher rate; and 3) her down payment fund. It has a respectable $10,000 already, but with her ideal house costing over $75,000, she’ll likely need more. Should she continue to whittle away at all three goals? Go all-in on the debt? Make other changes?

Pay Down The High Credit Card Interest With Low-Interest Savings

It may feel like a setback to see the down payment fund balance go down, but the spread between what credit card interest costs and what savings accounts pay makes using savings to pay off the credit card balance a no-brainer move. Even the highest-yielding online savings accounts are paying under 5%. Since my friend is opting for a neighborhood bank instead, she’s likely making less. With a credit card interest rate over 16%, she’d make 11% or more on any funds that move from savings to paying off the credit card debt.

Once that credit card debt is paid, the monthly credit card payment she used to make can instead replenish the savings balance. Without that required credit card payment, her DTI (debt to income) ratio will decrease, which will help with her mortgage application. Of course, this strategy only works if she doesn’t run up her credit card balance again!

Refinance The Car Loan To Pay It Off Faster

Though she’s paying more than the minimum on her car loan, at 16% interest, the loan balance will decrease slowly. She got an offer for a 9%, which I encouraged her to check out in more detail. If the new loan doesn’t have exorbitant fees and doesn’t have a longer duration than her current loan, then the lower interest will be a positive 7% return. She can win two ways: 1) if she keeps her monthly payment the same, she’ll pay off the loan faster; or 2) if she decreases the monthly payment to reflect the lower interest rate, she’ll improve her DTI ratio.

Confirm With Her Mortgage Banker Exactly How Much House She’ll Qualify For

It’s hard to hit any goal when you are not entirely sure how it’s measured. My friend is not sure how much she needs for a down payment and closing costs. She’s not sure how much mortgage she can afford. She’s not sure if her bankruptcy makes her ineligible for first-time homebuyer programs. The next step is to confirm as many of these unknowns as possible.

Her banker did say that the bank typically goes up to 37% DTI. The DTI ratio means that someone earning $2,000 per month could have debt payments up to $740, or .37% x $2,000. Knowing the bank’s maximum DTI and her own salary, my friend can calculate her maximum debt payment. That debt payment includes all debts – credit cards, student loans, car loans and mortgage.

Once she knows her maximum debt payment for the DTI ratio, she can back out how much house she can afford by estimating a maximum mortgage payment. For example, say she makes $3,500 per month gross. Then the 37% DTI means her maximum monthly debt payment is $1,295. Her car payment is currently ~$400, so the mortgage can be no more than $895 (assuming no other debts). At today’s 7% national mortgage rate, a mortgage balance of $130,000 would have a lower payment than $895, putting you under that 37% DTI maximum.

A Mortgage Is Not The Only Recurring Cost For A House

This doesn’t mean my friend should target a house costing $130,000. 7% is the national average, and with a bankruptcy she will pay an above-average rate. If she puts less than 20% down, that will add PMI (private mortgage insurance) to the mortgage, pushing the rate higher. In addition, home ownership requires property taxes, insurance and ongoing maintenance so even if you can borrow up to a maximum of 37% DTI, you may not want to.

Luckily my friend is interested in a house that costs just over $76000. At the 7% national average mortgage rate, a $76000 loan works out to $507 per month, well below the 37% DTI with enough buffer to cover PMI, taxes and insurance. Even if she pays a higher mortgage rate of 10%, the monthly is $668. Calculations are on the full $76000, so after a down payment, the monthly mortgage would be even less than these figures.

Small Steps Lead To Outsized Rewards

Home ownership is definitely within reach, now that my friend has been saving and paying down debts. Her credit score has been climbing since she’s made consistent, on-time payments (which is probably why she got that lower-rate car loan offer). She has an established relationship at her local bank, having opened a down payment fund and introduced herself to the mortgage specialist. Next stop is checking out first-time homebuyer programs to see if there is additional help she can qualify for. I’ll keep you posted if she buys!