Should I Pay Off Debt or Save for a Down Payment First?

The right answer depends on the type of debt you have, the interest rate on it and how it affects your debt-to-income ratio. In many cases the two goals do not compete the way they seem to at first. A lender can show you the real tradeoff using your own numbers.

Why this is not an either-or question

Every dollar feels like it can only do one job, so it is natural to see debt payoff and down payment savings as rivals. They do different things in a mortgage approval.

Your down payment affects your loan amount. In some cases it also decides whether you need mortgage insurance.

Your debt affects your debt-to-income ratio. That ratio is one of the main things a lender uses to decide how much you can borrow.

Once you know what each dollar is doing, you can make a more informed choice than picking one goal and ignoring the other.

How debt affects what you qualify for

Lenders calculate your debt-to-income ratio by comparing your monthly debt payments to your monthly income. A lower ratio generally gives you more room to qualify for a larger loan. It also tends to make your monthly budget more comfortable after you move in.

High monthly debt payments can limit how much home you qualify to buy. That is true even if you have plenty of cash saved.

When paying down debt should come first

Paying down debt first often makes sense in two situations.

• You carry high-interest debt, such as credit card balances.
• Your debt is pushing your ratio close to a lender's limit.

Bringing the ratio down can raise your buying power. Sometimes it helps more than adding the same amount to your down payment would.

Not all debt is equal. High-interest debt costs you more every month it exists, and it often has the largest effect on your ratio for its size. Paying down a high-interest credit card usually helps both your monthly cash flow and your qualifying ratio.

When saving for a down payment should come first

Saving first may get you into a home sooner when both of these are true.

• Your debt is limited to something like a low-interest auto loan or manageable student loan payments that are not straining your ratio.
• You do not yet have enough saved for a reasonable down payment and closing costs.

A larger down payment can also reduce or remove mortgage insurance, depending on the loan type. That lowers your monthly payment going forward.

Why the ratio is often the number to watch

Your debt-to-income ratio directly affects your loan approval and the amount you qualify for. If it is close to a lender's threshold, it is often the more pressing number to manage.

A lender can run your numbers and show you how much paying off one specific debt would change your qualifying amount. That turns a guess into a decision based on your own file.

How to build a plan that does both

Most buyers do not have to choose one extreme or the other. When you talk with a lender early, you can build a plan with two tracks.

• Pay down the debt with the highest interest rate, or the one that affects your ratio most, first.
• Set aside a portion toward your down payment at the same time.

A side-by-side plan like this is usually more effective than working on one goal alone. Loan guidelines differ from one lender and loan type to the next, so confirm the details with your lender before you move money.

Common questions

Does paying off all my debt guarantee me a better mortgage? Not automatically. It generally improves your debt-to-income ratio, which can raise how much you qualify to borrow. It may also improve your rate, depending on the overall picture.

Is a bigger down payment or lower debt more important? It depends on your numbers. A lender can show you which change has the bigger effect on your approval and monthly payment.

Is student loan debt treated differently than credit card debt? Lenders look at the required monthly payment on any debt when they calculate your ratio. The type of debt matters less than the size of that payment compared with your income.

Should I drain my savings to pay off debt right before I apply? Not usually. Lenders also want to see reserves and funds for closing costs. Talk with a lender before you make a large one-time payoff.

If you are deciding where your extra money should go right now, send us a message. We'll connect you with a lender who can run your numbers, because real figures make this choice much easier. You can also read our first-time buyers page.