Q&A

Should you Purchase a Home while Carrying Debt?

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By Peter G. Miller

Question:

We want to buy a home in the next few months. We have $40,000 in cash but also $8,000 in credit card debt. Should we pay off the credit cards? Answer:

There are a number of unknowns here such as how much you expect to pay for a home, the size of other debts such as cars and student loans, and your income. That said, you have enough cash to consider options.

The Federal Reserve reports that as of late 2020 – when mortgage rates reached an historic low of 2.66% – the typical credit card borrower was paying an average interest rate of 16.28%. For an $8,000 debt at 16.28% the annual interest cost is $1,302 or $108.50 a month.

The public is catching on. Data from WalletHub’s Credit Card Debt Study shows that Americans are ditching credit cards but that many households continue to carry high balances. The WalletHub figures for March shows several interesting trends.

In 2020 credit card debt fell by $82.9 billion. For the previous decade Americans had added an average of $54.2 billion in new credit card debt per year.

Average credit card debt amounted to $8,089 per household at the end of 2020, down 12% in a year.

As the economy re-opens in 2021, WalletHub expects credit card debt to increase by $50 billion this year.

In terms of real estate, credit card debt is a concern because of the monthly cost and the potential for credit dings if a payment is late or missed.

Lenders focus on a number of measures when they review mortgage applications. One of the most important is the debt-to-income ratio or DTI.

In basic terms there are two DTI measures. The first — the “front ratio” — compares monthly housing costs with gross monthly income. The second — the “back ratio” — includes required debt payments for such things as auto loans, student debt, housing costs, and credit cards.

With FHA-backed loans, as an example, borrowers generally need a front ratio of not more than 31% and a back ratio of 43%. However, it is possible to have even higher percentages and the back ratio can sometimes exceed 50%. In fiscal year 2020, HUD reported that almost a quarter of the loans it insures had DTIs of 50% or above.

There’s a lot of risk to lenders and mortgage insurance plans with high DTIs. With more risk comes higher rates, more expensive financing, and more mortgage application rejections for marginallyqualified borrowers.

In a situation where you have $40,000 in cash and $8,000 in credit card debt, speak with lenders and ask how best to use your funds. With sufficient income the monthly payments may not be a DTI problem. But, if your DTI ratio is a concern, then run the numbers to see how a debt pay-off could impact a mortgage application in your situation.

Email your real estate questions for Mr. Miller to peter@ctwfeatures.com.