Preparing to buy a home can be a confusing (and expensive) process. On one hand, you’re told to save a big pile of cash for your down payment. On the other hand, you may need to pay off debt to improve your credit and qualify for a mortgage. Before deciding to pay off debt or save, review our list of mortgage requirements to decide if there’s a better way to use your savings and prepare for home buying.
Should you pay off debt or save before buying a house?
Unfortunately, there’s no one-size-fits-all solution. But with a basic understanding of mortgage approval requirements, you can arrive at the best option for you.
If your funds are limited and you need help deciding whether to pay off debt or save money, this list of lender requirements can help:
Down payment amount
You’ve probably heard that you need a 20% down payment to buy a house, but the average down payment for a home is actually just 7%. You may even be able to buy a home with 3%.
Yes, having a bigger down payment can help you get approved for a mortgage with a lower APR and avoid paying Private Mortgage Insurance (PMI), but you don’t necessarily need 20%.
If you’re struggling to save money for a sufficient down payment, shopping around for a flexible lender or trying one of these loan options could help:
- FHA Loans: Some private lenders offer FHA-backed loans that only require a 3.5% down payment.
- VA Loans: Service members and veterans may qualify for VA-backed loans that don’t require any down payment.
- USDA Loans: The USDA provides mortgages for homes in rural areas, with no down payment required for low-income buyers.
- HUD resources: Visit HUD.gov to find state or local mortgage programs with low down payment requirements. A HUD housing counselor can also provide guidance.
Debt vs. income
Lenders also have requirements when it comes to your debt and income.
You may need to pay off debt before buying a house if your debt-to-income ratio (DTI)—the amount of your monthly income that goes to debt payments—is too high. For most lenders the limit is 36%, but some allow up to 43%.
To calculate your DTI, add up all of your monthly debt (the minimum payment amounts due) and divide it by your monthly income. Then, multiply the result by 100 to come up with a ratio. For example:
- Step 1: DTI = ($1,000 debt payments / $3,500 income) x 100
- Step 2: DTI = 0.29 x 100
- Step 3: DTI = 29%
If you need to lower your DTI, you can do it by paying off debt or increasing your income. Regardless of which route you choose, getting out of debt could add more time and effort to the homebuying process.
Credit rating
There’s no set minimum credit score to qualify for a mortgage, but many lenders require at least 620 for a conventional loan.
If your scores need to be higher for the loan you want, you may need to reduce your credit card and personal loan debt. When you do so, you can improve your debt-to-credit ratio (DTI), or the amount of available credit you’re currently using, and raise your credit scores.
The lender may also ask you to pay off debt in collections. While paying collections won’t necessarily improve your credit scores, it can show lenders that you’re in a better position to take on a mortgage.
If you’re hoping to save your cash for other homebuying expenses, you might look for a loan with low credit score requirements. Some FHA loans allow scores as low as 500 and VA loans have no minimum score.
Cash reserves
Even if you save money for a down payment and pay down your debt, you might still need more cash to get into a home. That’s because some lenders require cash reserves, or cash that’s left over after you close on the loan.
The requirement varies by lender, but in some cases, you’ll need two or more months of your full mortgage payment, including the principal, interest, taxes, insurance and HOA dues if applicable.
How does debt affect your ability to get a mortgage?
Being in debt can directly impact your ability to get approved for a mortgage. If you have a high DTI, lenders may determine that a mortgage payment isn’t affordable for you.
Carrying a lot of debt can also hurt your credit scores, which shows lenders that you may not be capable of managing a significant financial responsibility like a mortgage. Plus, credit scores can make it difficult to be approved for low interest rates.
How to improve your credit scores
No matter the condition of your credit, you can always improve your scores. If you’re looking for free or cost-effective ways to improve your credit so you can save your money for a down payment, try taking these steps:
Review your credit reports
Pull all three of your free credit reports through AnnualCreditReport.com. Review them to find areas for improvement and errors that could hurt your scores, including:
- Missed payments or unpaid/closed accounts that are there by mistake.
- Hard inquiries that you didn’t make.
- Accounts that don’t belong to you.
If you find an error on your report, you can file a free dispute with the corresponding credit bureau to have the information removed.
Become an authorized user
Becoming an authorized user on a friend or family member’s credit card is one of the fastest ways to improve your credit scores.
Once your name is added to the card, the account will appear on your credit reports as if it’s also yours. If the account has a low balance, no missed payments and it’s been open for several years, you’re likely to see a boost to your credit scores.
Increase your credit limits
Paying down debt is one way to improve your DTC ratio and credit scores, but you can also do this by increasing the limits on any credit card accounts you already have open.
If you ask, most creditors will agree to increase your credit card limits once a year. Just log into your account and submit the request.
Seek professional guidance
If you’re still unsure whether to pay off debt or save money for a down payment, talk to a lender you trust, like your bank or local credit union. Ask one of their mortgage officers for specific pointers on what needs improvement, whether it’s your down payment, credit scores or something else like your employment history.
A certified, nonprofit credit counselor can also help answer questions like, “Is it better to save or pay off debt?” after thoroughly reviewing your finances and your credit.
Written by Sarah Brady | Edited by Rose Wheeler
Sarah Brady is a financial writer and speaker who’s written for Forbes Advisor, Investopedia, Experian and more. She is also a former Housing Counselor (HUD) and Certified Credit Counselor (NFCC).
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