Pay Down Debt or Pay More Down?

 September 4, 2001, Revised February 11, 2008

Borrowers are sometimes faced with the problem of whether to use limited funds to pay down debt or to increase the down payment. The answer can be extremely complex, often depending on whether the allocation in one direction or the other will shift the borrower from one pricing or underwriting category to another.

"We plan to sell our condo and buy a house. We can use the money from the proceeds (after commissions, closing costs, etc.) to pay down our debts, or make a larger down payment. Which will have the larger effect on the amount of house we can qualify for? Which will have the larger impact on our borrowing cost?”

These are closely related questions, but not the same.

Impact on the Amount of House For Which You Can Qualify

Increasing the down payment will not increase the amount of house for which a lender will qualify you. Using the funds to pay down debt may, because debt is one of the factors used to assess the adequacy of your income, and it also affects your credit score. If the minimum monthly payments on your credit cards and all other debt exceed 8% of your gross income, or if you have a fistful of credit cards that are “maxed-out”, paying down debt might increase your house-buying capacity.

Effect of Debt Reduction on Expense Ratios: Lenders usually assess the adequacy of borrower income with two ratios. The "housing expense ratio" is the proposed monthly mortgage payment, including mortgage insurance, property taxes and hazard insurance, divided by the borrower's gross monthly income. The "total expense ratio" is the same but expenses include the borrower's existing debt service obligations. For each loan program, lenders set a maximum housing expense ratio, such as 28%, and a maximum total expense ratio such as 36%.

While the maximums may vary from one type of loan to another, or with other features of the transaction, usually the total expense maximum is 8% above the housing expense maximum. This means that if your monthly debt payments are less than 8% of your income, debt will probably not be a limiting factor on how much of a loan you can qualify for.

Even if monthly debt payments exceed 8% of income, debt will not be a limiting factor if your total expense ratio is below the maximum. For example, if the maximums are 28% and 36%, and your ratios are 24% and 34%, debt is not a limiting factor even though debt service payments are 10% of income. But if your total expense ratio is at the maximum and your debt ratio is above 8%, reducing your debt will permit a larger loan.

You can calculate your debt service payments as a percent of income now. You can’t calculate your total expense ratio because that requires knowledge of the loan amount and interest rate. However, you can use the affordability calculator on my web site to experiment with hypothetical numbers. That should give you a feel for the likelihood that your current debt service will limit the amount you can borrow.

Effect of Debt Reduction on Credit Scores: Debt also affects credit scores. Credit score may affect house-purchasing capacity by affecting the interest rate, the required down payment, or both.

Your ability to improve your credit score by paying down debt, however, is limited. If you have a history of payment delinquencies, repaying the accounts that have been delinquent will not raise your score. A poor payment history can be neutralized only by a good payment history, and that takes time.

You may be able to improve your credit scores modestly if you have many accounts, and the balances are at or close to the maximums. While the scoring rules are not fully known, you can probably increase your credit score by paying off bankcards in excess of 4, and reducing the balances of the cards remaining -- 30% of the maximum is a good objective.

Whether or not an increase in credit score will increase your house purchase capacity depends on what your score would be with and without debt repayment, and whether the better score would qualify you for a lower down payment requirement, which would increase your purchasing power. For example, if the debt reduction raised your score from 670 to 700 and lenders allow 5% down at 700 compared to 10% at 670, you would be able to qualify for more house.

The circumstances under which debt repayment will increase house-purchase capacity are thus very “iffy”. It is going to be difficult to pin them down until you go through the process of qualifying for the loan needed to buy a property at some price. That’s why someone in your position needs a skilled professional to guide them through the process.

Impact on Borrowing Cost

Lenders price mortgages using notch points for many variables, including both FICO scores and down payments. A notch point is a critical point at which your borrowing cost changes.

On down payments, notch points are quite uniform across the market. They are 20%, 15%, 10%, 5%, 3% and 0%. This means that, e.g., if you can increase your down payment from, e.g., 3% to 5%, 7% to 10%, 14% to 15%, your borrowing cost will decline. This decline could take the form of a lower mortgage insurance premium, a smaller second mortgage for the amount of the loan over 80% of property value, and possibly a lower rate on the second mortgage. But increases in down payment from, e.g., 5% to 9% will not affect borrowing costs because it doesn't shift you into a new slot.

Notch points on credit scores have generally varied widely, but 720, 680, and 620 are common. In January 2008, Fannie Mae and Freddie Mac introduced loan surcharges based on credit score, applicable to all borrowers with scores below 680. The charge was .75 points for a score of 660-679, 1.25 points for a score of 640-659, and 1.75 points for a score of 620-639.

A Third Option: Wait Before Buying

A reader took me to task for not pointing out a third option. The buyer could delay purchase until he had both the required down payment and zero debt. The reader pointed out that no matter which use the buyer made of his funds, any emergency such as a required new roof or heating system, would leave him strapped.

It is a good point, too many people buy houses before they are ready. Being ready can be defined as being able to make a down payment, having a fund on top of that for emergencies, and not having significant debt.