Deciding to buy a home involves a lot of planning and research. One of the most important aspects is the financial planning—making sure you buy a home that you can afford over the long-term. If you have debt and your credit score is not high, then your planning process may be slightly more complicated, and you may face some difficult decisions. You may find yourself struggling to decide whether you should buy a home now, or clean up your credit and debt first. A few factors can go into this decision.
Loan Type and Interest Rate Impact
We recently published an article relevant to this topic about the best time to buy your first home. In that piece, we discussed three key financial factors in the decision—your credit, purchase price, and down payment.
Your credit is going to determine the types of loans you are eligible for, and it will determine the rates offered on those loans. Ideally, you would want a conventional loan with the lowest interest rate possible. A conventional mortgage typically requires a minimum credit score of 620. The best interest rates are available to borrowers with scores above 760.
For example, take a look at this chart from myFICO.com, which demonstrates how a low credit score could lead to a high rate and thus a more expensive monthly payment:
That’s not to say you can only buy a home if your credit is in great shape. You could opt for an FHA loan, or a conventional loan with a higher interest rate. You will need to make a personal decision about how important it is to buy right now as opposed to waiting while you improve your credit.
Debt can affect your ability to take out a mortgage because it directly impacts your debt-to-income ratio (DTI). There are two types of DTI, a front-end and back end. The front-end ratio is calculated to determine how much of your income would go toward housing expenses. Lenders calculate the back-end DTI by dividing your monthly debt by your gross monthly income.
Ideally, for a conventional mortgage you would have a back-end DTI of 36 percent or lower. You still could get a mortgage with a higher DTI, say up to 50 percent, but you will likely receive less favorable terms. Also, a lender might approve you for a smaller mortgage than you want (further limiting your purchasing power) based on your debt load.
Other Costs Not Captured in DTI Calculation
The use of debt-to-income ratios has one major shortcoming. DTI does not capture expenses other than debt. This means that if you have significant monthly expenses like food costs, high transportation expenses, education expenses, etc. then your money may be even tighter than a lender realizes. This could mean that you are approved for a loan that is actually very difficult to manage and make payments on.
If you have a hefty debt load, be sure to look beyond your DTI and take these other costs into account.
The Market: Is Now the Right Time to Buy?
Another thing to consider is the state of the housing market where you are planning to buy. Right now, many major markets across the country are sellers’ markets and housing inventory is low. This can drive up prices and make the bidding process very competitive. This would not be an ideal environment to have significant debt and credit concerns, because you may not have the purchasing power you need, and sellers may prefer buyers who bring more favorable loan terms to the table.
On the other hand, timing the market is difficult. No one can say with certainty whether prices will go up or come down in the near future. You should consider how long you plan to stay in your next home. If your upcoming move will be a long-term move, then buying makes more sense than if you are planning something short-term. Evaluate things like your job, school for your kids, commute times, and any other applicable concern when deciding this.
You should also research your local market, and consider talking to a real estate professional to get a better sense of the local dynamics.
If you have significant debt and your credit score is not quite where you would like it to be, you should focus on solving the underlying problems. However, that does not mean you cannot buy a home. You will need to determine whether it makes sense to wait or whether it would be better to move forward with a home purchase now. The right answer depends on your situation, including your local real estate market, your future plans, and your other financial obligations.