We would like to purchase a home in the next year. Our credit scores are in the 700's and we are trying to decide if we should pay down some debt or save up money for a larger down payment. Which would you recommend?
—Lauren & David, Grand Junction
Dear Lauren & David,
That is a great question and there are many factors to consider.
Let me start with a simple calculation that may surprise you. On average for every $10,000 you apply towards your down payment, you will save approximately $50 per month on your payment. Now $50 per month savings may sound great, but it will take you approximately 16.5 years to breakeven on that extra $10,000 you applied towards your down payment! Possibly that is extra money you could apply to new carpeting, kitchen cabinets, emergencies, etc. once you have moved into your new home.
The same applies with buying down your interest rate. We all like to brag about the great rate we got on our new loan, but the Annual Percentage Rate (APR) is just as important since it is the cost of the loan in percentage terms considering various loan charges of which interest is only one such charge. Other charges used in calculating the APR are Private Mortgage Insurance or FHA Mortgage Insurance Premium (when applicable) and Prepaid Finance Charges (loan discount, origination fees, prepaid interest and other credit costs. The APR is calculated by spreading these charges over the life of the loan which results in a rate higher than the interest rate. If interest on the loan was the only Finance Charge, then the interest rate and the APR would be the same. Hypothetically, let's say it costs you $2000 to buy your interest rate down from 4.50 percent to 4.25 percent and it saves you $40 per month on your monthly payment. In this case it will take you over 4 years to break even on that extra $2,000 you applied to buy down your rate vs. saving it towards future repairs, enhancements to your home, etc.
When I talk with prospective home buyers, I always want to understand both your short term and long-term goals with owning a home to determine the best loan options, down payments, etc. Answers to these questions can determine if you should make a larger down payment (if that is an option), pay for mortgage insurance upfront or include it in your monthly payment and if should you pay down your interest rate.
While you may want to save up for a larger down payment to avoid mortgage insurance, by paying down your debt your FICO score could increase and help lower your interest rate and mortgage insurance. My recommendation is not to focus solely on the down payment, because there are many factors to consider that will determine your monthly payment.
Lenders will look at debt-to-income ratios to determine the mortgage amount you can qualify for. The front-end ratio looks at your total new mortgage payment, including principal, interest, taxes, insurance and your HOA dues. Most of the time, your payment should not exceed more than 33 percent of your total gross income. The back-end ratio includes your new mortgage payment and all your remaining debt. This should not exceed more than 41-45 percent of your total gross income. There are loan products that may allow you to have higher ratios and your lender can help identity these if it is needed.
It is also important to have cash reserves or savings accounts that will cover your down payment and closing costs. Certain loans allow you to have a gift or down payment assistance.
I encourage you to reach out to your lender and they can help provide you with the many loan options available for home ownership. Feel free to contact me directly if you have further questions.
Branch Manager, NMLS #1721861
Cherry Creek Mortgage