Monday, August 07, 2006

Is it better to pay down debt or save for a down payment?

In my case, since I have a gross income of $2500 a month, this is a pertinent question even more than it is for people with higher incomes. The debt service can significantly cut into how much house you can be approved for, because a regular payment of debt service is a lot bigger chunk of $2500 than of $5,000 or $10,000.

At my income, with no debt service and no down payment, on a 7% 30 year mortgage with $1000 homeowner's insurance (I have no idea how much these things cost) and $1500 property taxes (about right for the size of house I would buy), Bankrate says I can qualify for about $103,000. That seems pretty good to me!

My question here is, should I bother saving for a down payment, or is it more important to eliminate my $6800 in credit card debt? I don't think I could do both in a short period of time unless my income rose substantially, and hell, if my income rose that much I could qualify for whatever I wanted anyway. So let's assume that I can either pay down the debt, or save up $6,000 (on account of having to pay minimums on the credit card while saving.)

My minimum payment right now is $140. So if I had an extra $140 debt service, with no down payment, I could qualify for only $62,000. If I had the $6,000, I could qualify for only $6,000 more, or $68,000.

However, if I went into my mortgage with no down payment at all, but also no credit card debt, showing only my student loans, I could qualify for $83,000.

This exercise is pretty clear to me. Paying off my debt and reducing the monthly amount of expenses significantly increases the amount that I can borrow, because I'm paying the debt service into the mortgage instead of the card.

What about my student loans? How much more house could I get if I reduced the payments as much as possible? All of my loans are consolidated with Sallie Mae, so they have a number of payment plans. The Grad Choice plan appears to lower the payment substantially for two years (presumably while you are in graduate school) - for me that would be $51 a month. I could qualify for $96,000 with that loan - but the payments would rise to $151 permanently after two years, which wouldn't be so bad since I'm already paying $150 on them now. You have loan options with the reduced payment from 2 to 5 years - the 5-year-reduced option is $62 a month for five years and $184 a month after that - ouch. In order to get the most mortgage, the best plan would probably be to take the 2-year reduced, just to get through the mortgage-acquiring process, and then switch back as soon as possible. While that would certainly get me a larger mortgage, I don't think I'd want both a larger mortgage payment and a rising student loan payment at the same time. But it might be an option to try to get a better rate and allow at least a little flexibility above what I might otherwise qualify for.

This is also a really good example of why I absoLUTELY cannot buy a car with a loan, if I want to think about buying a house. Even a tiny loan payment would really knock down the amount I could qualify for on my own. So in this case, if we move into a house that's far enough from work that I need to drive, it would make a lot more sense to buy a car in cash than to use that cash for a down payment. But what effect would having even a small downpayment make on what rates I could get?

I checked with my credit union's online calculator, and I can get a 100% LTV at 7.375% from them, although I would get a slightly better rate (7.125%) if I had $3,000 for a 97%, or $5,000 down for a 7/1 ARM at 6.5%. (Anything that is not one of those 30 year plans has to have at least 5% down.) A 20-year loan would get me 6.5%. But in order to actually get the $5,000, that might require not paying down the debt as aggressively... Ah, to have enough money to do both. =) As with everything, I think the answer is going to be, do both! So I'm going to try to get the $5,000 together, while lowering the debt as much as possible. I think in the long run I'll save more money and get a better loan if I can qualify for a regular loan, if I have 5%, than if I have no debt and also no money.

Around here, I could actually get a nice little house for $83k (because I don't intend to have children and send them to school in that area) and the mortgage payment would be only $550, which is a lot less than our current rent of $695. I'm thinking about houses because depending on how Boyfriend's career situation goes, we might be staying here for several years, in which case I'd like to buy a house, and he has agreed that it would be best if I bought it and he paid me rent, to avoid possible troubles if we break up (and also because he won't be paid much during those years anyway.) So it's something to think about for the future.

9 comments: said...
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prlinkbiz said...

I know you want to be debt free, and I admire that. I know everyone's risk tolerance is different. (Plus your a numbers girl!lol)
Consider this- your credit score is fabulous. I bet you could get a 100% loan if you shop around. Find a house that is undervalued, buy it no money down, and then immediately do a heloc and pull out the equity that is there. You can use it to pay down you other debts, or use it to hold the property so you can pay down your other debts. A house is a great way to make your money work for you, and help you get where you want to go a little faster.

Kira said...

Yes, I stated that I could get a 100% LTV loan at 7.375% right now, and I do have enough income and a good credit score. Right now though there are 2 big issues: 1, I don't know how long I will be staying in this city. Depending on the events of the next year, I might be staying here until January 2008, or for the next six years. I don't really know yet. So I'm waiting until I know to do anything.

2. I don't have a car, and I walk to work. It would take a lot of searching to find something affordable nearby or on a direct bus line. So I need to have the cash in hand in case I find something great not on the bus line, so I can buy a car instead of using it as a downpayment, instead of trying to do both at the same time.

I don't really have a lot of debt and all of it is at below-HELOC interest rates, so that wouldn't make much sense for me.

Jessica said...

be careful of this if you decide for no down payment...

Private Mortgage Insurance (PMI)

If your down payment on a home is less than 20 percent of the appraised value or sale price, you must obtain private mortgage insurance, known as PMI, with your lender. This will enable you to obtain a mortgage with a lower down payment because your lender is now protected against any default on the loan.

PMI charges vary depending on the size of the down payment and the loan, but they typically amount to about one-half of one percent of the loan, according to the Mortgage Bankers Association of America. Mortgage insurance premiums are not tax deductible.

Let's say you put down 10 percent or $10,000 on a $100,000 house. The lender multiplies the 90 percent loan, or $90,000, by .005 percent. The result is an annual PMI of $450, which is divided into monthly payments of $37.50.

Most homebuyers need PMI because 20 percent of the sale price on a home is a lot of money; for instance, that's $20,000 on a $100,000 home. Homebuyers must maintain the PMI premiums until they cross that one-fifth-of-principal threshold, a process that can take years in longer-term mortgages.

Kira said...

Yeah, PMI is kind of a drag.. but it would take a lot longer to save up the 20%, than it would to pay down the debt enough to get rid of it, since I could be putting both my current rent money and the money I'm currently saving for the downpayment towards the mortgage, whereas if I wait and save up 20% I still have to pay rent. (And my rent is about what my payment plus insurance and taxes would be.

Padraic said...

Since you're planing on making a purchase sooner rather than later, I would recommend against paying down your credit card while saving as much cash as you possibly can. Obviously don't increase your debt. Cash is King and lending institutions like to see lots of cash, rather than less debt. Once you've closed on the house, if you have extra cash you'll have a lot more options.

To avoid PMI you may wish to consider a home equity line of credit. The HELOC will have a higher interest rate, but is deductible and you're building equity rather than paying insurance premiums.

Good luck!

Kira said...

The issue for me is that since I don't make very much, and I'll be a single applicant, any required payment seriously cut into my debt-to-income level, and have a huge effect on how much house I can qualify for at all. If my income rises substantially I'll go much more towards accumulating cash, but right now if I don't pay down the debt, I won't qualify for a large enough mortgage to buy any kind of house, even around here.

Then Things said...

I would be agressive about paying down the debt for now, then once it's gone start saving up for a down payment fund. Is 2500 after-taxes? If so you should be able to get rid of 6800 in no time! I make about 1800 a month after taxes and can put $550 a month into my down-payment savings fund (I don't have CC debt) so Iif you could do $500 a month on that debt you could pay it off in a little more than a year (I would put even more than that towards it if you can, as much as possible).
I would not even think about purchasing a house until you're absolutly certain about how long you'll be in the city where you live. For you it sounds like you'd probably be better off finding somewhere with really cheap rent since you won't have a down payment and it sounds like you won't be able to easily afford the mortgage alone if something happens with the BF.

Kira said...

$2500 is pre-tax, $1800 post-tax. (Yea, I initially thought the same thing when I saw the $2500 number.. wow, I'll be able to save $1000 a month!)

I'm not going to purchase anything until after next year when Boyfriend decides whether he is going to get a PhD here. If so, I'm perfectly happy to stay in this city, and that'll be at least five years here. (More if they hire him.)

Our rent right now is $695 a month, which we split, and the mortgage amount I'm looking at would come out actually to less than that, including property taxes and homeowner's insurance, so that there's wiggle room in the budget for inevitable repairs.