Pay Off Credit-Card Debt Before Buying a Home? Maybe Not

While getting your financial house in order before you try to purchase a home is an excellent plan, paying off all your credit card debt may not be the best move.

Ironically, some of the steps you take that are great financially (such as reducing debt and canceling your credit cards) are not always helpful when you are applying for a home loan. Reducing your debt will impact your credit score, your debt-to-income ratio and the cash you have in the bank, so consider all three aspects carefully before you make a final decision about your credit card balance.

Cash Reserves and Credit Card Debt

If you are thinking of buying a home, you have likely implemented a robust savings plan to build a fund for your down payment and closing costs. Think hard before you dip into that fund to pay off your debt.

The median price of a home in the United States in 2014 is around $200,000, so you will need at least $7,000 for a down payment for an FHA loan that requires 3.5% down; or $10,000 for a 5% down payment, the minimum required for most conventional loans. In addition, you will need 3% to 5% for closing costs, which comes to another $6,000 to $10,000. So far, you will need between $13,000 and $20,000 in cash to buy a home.

You will also need money for moving expenses and for cash reserves in case of an emergency. Not all lenders require cash reserves, but to be safe you should plan on having at least two months of mortgage payments on hand.

Once you have estimated all these costs and determined that you can cover them and still have cash available, paying off your credit card debt would be smart financially.

Debt-to-Income Ratio

In order to qualify for a conventional mortgage, your monthly minimum payments on all debt must be a maximum of 43% of your monthly gross income. Some lenders require lower debt-to-income ratios, particularly for borrowers with a low credit score or few cash reserves. If your credit card debt is too high, you may not be able to qualify for a mortgage. FHA loans have looser guidelines, so some lenders may allow a higher debt-to-income ratio under special circumstances, but for your own comfort level with your budget it’s best to have a lower debt-to-income ratio.

Credit Score Issues

Lenders rely heavily on consumer credit scores, not only for a loan approval but also to determine the interest rate you will pay for a conventional loan. If your credit score is under 700 or 680, you may want to pay off some or all of your debt to improve your score. If your score is 640 or lower, you may qualify for an FHA loan depending on the rest of your credit profile.

If you decide to reduce your debt, be careful not to consolidate all your debt on one credit card. Doing that can hurt your credit score more than having a low balance on several cards. Even more important, don’t close any credit card accounts. This will reduce your overall credit availability and shorten your credit history, both of which will lower your score.

One of the best ways to make the decision about your individual financial situation is to consult with a mortgage lender who can advise you about the best way to qualify for a loan that’s affordable and fits your money management plans.