Why Paying Off Debt Could Actually Hurt Your Homebuying Chances

How you plan and budget your finances can have a big effect on whether or not you can qualify for a home loan. For sound financial planning purposes, eliminating the expenses in your life that contain the highest interest rates first is generally a good approach. After all, why pay more interest, right? But when you apply for a mortgage, the paradigm shifts from paying off high payment obligations to prioritizing paying off debts that can improve your borrowing power. With that in, here are a few things prospective homebuyers should consider.

Banks generally do not give any brownie points for you electing to eliminate high-interest debt, but they will score you favorably by paying off debts with big payments.
Banks generally are not interested in the terms of your consumer debt obligations.
Banks are generally covering themselves first as they are bearing all the risk.

Banks and mortgage companies do factor in what you are obligated to pay each month as a benchmark for determining your credit capacity. This approach might not sound very logical to someone who has a large payment on a credit obligation with a great low interest rate.

Income Remains Supreme

A mortgage is a loan primarily against your income. The simple concept of income to offset a debt payment is what lenders look for among other things like credit, character, collateral and capacity, but income remains supreme. Gross monthly income less payments on current obligations (not what you choose to pay, but just the minimum amount owed) is how lenders will generally determine how much borrowing ability you have. (Credit scores will factor into how much interest you pay on your mortgage. You can check your credit scores for free on Credit.com to see where you stand.)

Consider a car payment at $400 per month (0% interest rate) for a remaining balance of $10,000 versus a credit card payment at $200 per month (16.99% APR) for a remaining balance of $5,000.

If you had an extra $5,000 to pay with, paying down the car would make more financial sense for buying a home than paying off the credit card, even with a 0% APR. Your payment-to-income ratio drives how much house you can really buy. Lenders compute your payment-to-income ratio in the following way:

Sum of your total current payments + proposed total housing payment ÷ monthly income = debt ratio.

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Generally, with the exception of Federal Housing Administration Loans, this ratio figure cannot be more than 45% of your total income. In our car example above, paying off the car loan would free up $400 per month in borrowing ability for a mortgage. This translates to about $40,000 in home-buying power, quite a large number indeed, especially if you’re in a competitive market.

You can follow these steps when you’re getting pre-approved:

First and foremost, pick a reputable, experienced lender.
Identify which debts have the least balances containing the highest monthly payments.
Ask your lender to run scenarios including what you qualify for now with the obligations as is and what you could qualify for if those liabilities were paid off. It’s important to make sure those monies do not hurt the down payment or closing cost figures.
Congratulate yourself on a job well done. Your prudent budgeting may have just opened a door to a new neighborhood.

Every Situation is Different

Each and every homebuying situation is uniquely different. This information may or may not pertain to your specific situation. The whole concept is to cherry pick the obligations that pose the biggest threat to your homebuying ability and pay them off in full if possible. By paying off high debt-payment credit accounts, you also demonstrate you can actually afford the home and subsequent payment you are applying for.

This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its partners.