How to Buy a Home When You're in Debt

Spring is here already. Are you lining up your finances for a home purchase this year? And are you not sure whether to put more money toward paying off other debts or your upcoming down payment? Here’s how to figure out the best strategy to improve your figures.

Here are some key questions to ask yourself:

How much house payment can I manage while still being able to save money?
How much house payment can I manage while saving money and paying off my consumer debts?

If you have access to the extra cash, you have choices on how much house payment you can really handle to best position yourself for the long haul so you’re not married to your mortgage and your other payment obligations.

Essentially, you need to look at your long-term housing plan. If you don’t know, start with a five- to seven-year projection.

The key is to determine the best use of your dollars so as to reduce debt while being able to manage a mortgage payment. Put simply, consider a mortgage payment low enough that you still have funds left over to put toward debt, if applicable, or to savings. In other words, don’t bite off more than you can chew.

Easier said than done, right? It doesn’t have to be. Perhaps you put extra money into prepaying your mortgage every month, which would save you thousands of dollars in interest over the term of the loan — that’s a no-brainer benefit. Alternatively, it could mean putting more down on the house upfront to have a lower mortgage payment so you can then focus on paying down the consumer debt over time once you have the home.

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However, the best possible scenario from a financial planning standpoint would be to have very little, or no, debt of any kind and carry a bigger mortgage payment — meaning buying the house with less money down. Why? Well in most scenarios consumer debts carry no tax benefit. A bigger mortgage means a higher mortgage payment, but when you factor in that your deductions improve by having a slightly bigger mortgage on your home, it might make more sense to pay off your debt first and use less down for the home sale.

Bigger Down Payment vs. Paying Off Debt

Let’s look at a couple of potential scenarios for a would-be homebuyer who’s in debt. The homebuyer has:

A 725 credit score
$8,000 per month of income
$40,000 of consumer debts with payments at $700 per month
$450,000 home price
$100,000 total cash available to spend on buying a home including down payment and closing costs

Scenario 1

Down payment: 20% down = $90,000
Loan amount: $360,000 with a 30-year fixed rate mortgage at 3.875%.
Total mortgage payment: $2,210 per month (including homeowners insurance and taxes)
Total liabilities each month: $2,210 mortgage payment + $700 to consumer debts = $2,910 per month

Scenario 2

Down payment: 10% down = $45,000
Loan amount: $405,000 with a 30-year fixed rate at 4.125% (to accommodate lender-paid mortgage insurance in order to avoid an extra $175 per month in private mortgage insurance)
Total mortgage payment: $2,480 per month (including homeowners insurance and taxes)
Total liabilities each month: If you use to remaining cash to pay off consumer debts, that would leave no other debt payments, just the mortgage payment at $2,480 per month.

The net difference in these two scenarios is a whopping $430 per month. An extra $430 per month can give you $40-50K in additional buying power, meaning you could potentially buy more home with a lower payment. This can give you an edge in competitive market.

The extra $430 per month generating by paying off your other debts could also very easily be used to either prepay the mortgage payment — especially if you’re already used to paying on a higher debt load on a monthly basis – with no disturbance to cash flow.

Or another smart step to take would be to pocket the money and build your savings for leaner times.

Not What You Pay, But What You Owe

In the majority of the cases, investing the cash to get rid of the consumer obligations — even if the consumer obligations are 0% interest — more than likely is going to calculate favorably in the eyes of the mortgage company. Why? Mortgage companies look at minimum payment on each obligation each month. If you pay more, great, but don’t expect the bank pat you on the back.

Know this: What might be a low-risk loan for the lender does not necessarily translate to what might be a low-risk loan for you as a would-be home buyer, so it’s important to work with your loan officer to make sure you’re getting the best scenario for you.

If you know for certain that you can pay the higher down payment and pay off other debts while maintaining a mortgage payment, that could be a win-win whenever the consumer obligations are paid off. For example, this type of approach could work very nicely if your income is poised to rise in the future, or if you’re going to be coming into some cash — perhaps a gift, an inheritance, a promotion, a big commission … whatever the case may be.

The challenge when buying a home is when you already carry a large amount of debt. This is what the mortgage company uses to decide how much home you can qualify for. In this situation, using a small down payment cuts your buying power. Then you might want to consider any of the following offsets:

Paying down your other debts either with your own funds; possibly with retirement funds, if necessary, or a gift.
Switching loan programs, for example going with a loan with traditional mortgage insurance to a loan with lender-paid mortgage insurance to reduce your debt-to-income ratio.
If you changed jobs and got a salary increase, the lender may consider it but will need an offer letter and a supporting pay stub.
Getting a co-signer.

A note on getting a co-signer: If you are completely maxed out with the mortgage payment against your income plus other debts, this will help you qualify. Be aware, though, that it may not be the best move from a financial planning standpoint. Better to evaluate whether your income could increase over time, or you could pay down your debts – resulting in a more stable financial situation down the road

Even reducing your other debts by as much as $500 per month can give you $100,000 in additional buying power. Whichever strategy you chose – putting your money into a higher down payment or toward paying off debt — ultimately is your decision to make, but make sure whichever route you choose is the more manageable situation for you.

Before you begin the homebuying process, it’s a good idea to check your credit reports and credit scores to see where you stand. Make sure there are no errors on your credit reports that are dragging down your score. You can get your credit reports for free once a year from AnnualCreditReport.com, and you can get your credit scores for free from Credit.com, updated every 14 days so you can watch for changes.