Should You Pay Off All Your Debt Before Buying a Home?
Sometimes borrowers have a natural inclination to pay off all of their debt in hopes of improving their odds of an approval with favorable conditions. When purchasing a home, paying off debt may slightly improve your scores and DTI, but it may do more harm than good. In some cases, it may do no good at all. It may just put you in a worse position with absolutely no benefit. Here’s what you need to know about the realities of paying off debt in pursuit of a home loan or refinance.
Buying a home is the biggest purchase most Americans will ever make, and it’s extremely important to put yourself in the best position financially before making the purchase. Strategic debt reduction and credit optimization over several months is the best way to make sure your monthly payment is as low as possible. Once your loan is locked in, changing the terms of the loan isn’t easily done.
The Importance of Timing
One minor problem you might face when paying a debt simply comes down to timing. Credit bureaus update slowly. It’s not uncommon for borrowers to wait 60 days before their lower balances actually reflect on their credit report. Most lenders can do a rapid rescore, but it costs the lender a considerable amount of money to do so. It’s important to know when paying a debt is actually beneficial.
Staying on the topic of timing, if you’re purchasing in the next 6 months to a year, avoid credit applications or major purchases of any kind. This includes cosigning with someone else. There are a couple of reasons for this. Adding a new account or credit application to your credit report will come with a hard inquiry. This will bring your scores down 5 points initially. Mostly, you want to avoid new accounts, because it instantly lowers your average length of credit. The longer your existing credit, the more a brand-new account is going to harm your credit scores.
When Paying Off Debt CAN Be Beneficial
Conditional Approvals
Start by considering situations where paying off a debt CAN be beneficial. Underwriters often issue conditional approvals that require certain debts to be paid before closing. These are typically collections or past-due accounts that the lender wants resolved before moving forward.
It’s important to remember that paying a collection almost never removes it from your credit report. While the balance may update to $0, the collection itself will usually remain, and WILL negatively affect your credit scores.
High Credit Utilization
In other cases, a lender may ask you to pay down or pay off an account that is maxed out, since high credit utilization can impact both your scores and your risk profile. Eliminating a large monthly payment, such as a car loan, can also significantly improve your debt-to-income ratio, which is a key factor in mortgage approval.
Unintended Consequences of Paying Off Debt
However, paying off certain accounts can sometimes have unintended consequences. Closing a long-standing installment account, for example, may slightly hurt your credit scores by affecting factors like credit mix or payment history length. In other words, what’s good for your overall finances doesn’t always translate into an immediate improvement in your credit scores.
Keep in mind that DTI is calculated by totaling your monthly payments and dividing that by your monthly income. If you paid off an $80,000 student loan, but the monthly payment for the loan was only $75, then you’re not having a huge effect on your overall debt-to-income. What you HAVE done is drain your bank account and close an account that was doing more to help your credit scores.
Different Loan Programs Have Different Rules
Approval depends on multiple financial factors. Those factors are different for different loan programs. For example, conventional loans cap DTI around 43-45% while FHA can go higher. The VA doesn’t have a strict maximum DTI threshold. 41% is the standard, but VA is more flexible than other loan programs. Your debt payment strategy will also be different for different loan programs.
Cash Reserves Matter
Making sure you have cash reserves, also called mortgage reserves, is required. This is the amount of liquid assets you possess after your down payment and closing costs. Lenders want to see anywhere from 2 to 6 months of mortgage payments in reserve in the case of a financial hardship like job loss or illness. This is going to be the bare minimum that you’ll need to get approved. That’s not including the inevitable early homeownership repairs and upgrades required to make your home yours.
Lowering your monthly payments IS important. You have to look at each account. Spending a lot of your cash reserve paying off accounts that aren’t going to move the needle in a meaningful way is futile.
What You Should Pay Off
Credit Cards
Paying off credit cards to get your utilization as low as possible is a must. There’s no way around it. It has such a high impact on your credit scores that not doing so doesn’t make sense. You should pay these accounts down at least 60 days before your pre-approval and keep them paid down throughout the approval process.
Getting your utilization under 30% should be the goal, although the less revolving debt you have the better. Getting utilization into the single digits is where you will see the maximum benefit.
Medical Debt
Paying medical debt is wise in certain scenarios. The credit bureaus have ceased reporting paid medical debts, medical debts under $500 and any medical debts that have been incurred in the last 365 days. Some lenders and loan programs don’t recognize medical debt at all. Speak with your lender about medical accounts before rushing to pay them. Save your cash if paying an account won’t get you closer to your goal.
Removing Negative Items From Your Credit Report
Removing or correcting negative items on your credit report is also extremely important. A few creditors will still offer pay-for-deletions. You shouldn’t shy away from this if it’s offered. Make sure this is offered in writing. Preferably a document they send for signature.
Pay-for-Delete and Newer Scoring Models
Pay-for-delete has become a lot less common, but newer scoring models like FICO 9 and Vantage 3.0 already ignore paid collections. Some lenders are already starting to use these newer models. As more lenders start using the newer models, the need for pay-for-deletes may decrease significantly.
Credit Repair Companies
There are reputable credit repair companies that can help remove negative items from your credit report by leveraging federal and state consumer protection laws. Unfortunately, there are also companies that claim to offer credit repair but either take your money and do nothing or they do things you could easily do yourself. Before hiring a company to help with your credit, make sure to do your research and choose one you can trust.
Don’t Wait Until the Last Minute
Lastly, allow the credit bureaus plenty of time to update. That means if there are changes that need to be made to your credit report, you need to make those changes sooner rather than later. Don’t wait till the last minute to pay off conditional accounts, pay down credit cards, or hire a credit repair company.
Here’s the reality: if you need to be in a home in 60 days but you have maxed out credit cards, large collection accounts, high DTI and low cash reserves, you are months behind the curve.
You should start taking steps to correct these issues early. Making the right decisions over a period of months and years will always be your best bet when it comes to home loan approval. Don’t wait until you need your credit or cash reserves to start doing these things.