Pay Down Credit Cards or Save For a Down Payment?

July 17, 2006, Revised February 24, 2007, January 14, 2008

"Should we pay off our credit cards before saving for a down payment? Or is there a point where it makes sense to make the minimum payments on our cards and bank the rest for a down payment?"

There may well be a point where it is prudent to shift the allocation of your excess cash flow from paying down credit card balances, to building up your down payment, or vice versa. Finding that point, however, can be a challenge.

Setting a Target Down Payment

The key is to set targets. That is easiest to do with the down payment, so lets start there. Generally, the larger the down payment the lower the cost of the mortgage. The cost 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.

The relationship between down payment and mortgage cost, however, is notched, not smooth. If you go from nothing down to 3% of the sale price, the cost of the mortgage will drop, if you go from 3% to 4%, it won’t, but from 3% to 5% it will. While there are exceptions, the major notch points are 0%, 3%, 5%, 10%, 15% and 20%.

Your down payment target should be a notch point that is within your reach during the period you have set aside for the process. In making your plans, keep in mind that you will need some cash for settlement costs in addition to down payment. Figure another 2%, although that figure can vary widely in different areas.

If you are starting with 2% in the bank, you probably would target 3% down. If you start with 7% in the bank, you might target 10% down. And so on.

Setting a Target For Total Debt Service Payments

Credit cards can affect your ability to qualify for the loan amount you need. Your required monthly payments on the cards are added to the payments associated with the mortgage in determining how much you can afford. Lenders calculate a maximum "total expense ratio", which is the sum of the mortgage payment, property taxes, homeowners’ insurance premium, and other debt service including credit cards, all divided by the borrower’s gross income.

If your ratio exceeds the limit when it includes your credit card debt service but would not exceed the limit if your cards were paid off or reduced, then you want to target lower card balances. How much reduction would be necessary is impossible to say in the abstract, but here is a good rule of thumb. If your total debt service payments including credit cards (but excluding the mortgage) is below 8% of your cross income, it will not limit the amount you can borrow.

That doesn't necessarily that if your ratio is above 8%, you should set an 8% target. But it might mean that, especially if your credit score is not too good.

Paying Down Card Balances to Improve Credit Score

Credit cards play another role in preparation for a home purchase. They have an important impact on your credit score, which in turn may affect both the price of your mortgage and the amount for which you can qualify.

Making timely payments is extremely important and requires no elaboration here. The question is whether paying down your card balances will raise your score? It will if your existing cards have high utilization ratios -- meaning that the balances are high relative to the maximum balances set for each card. Your target should be utilization ratios below 50% on every card. If you have more than 5 cards, target 5 by paying off the newest cards. Of course, you will avoid taking out new cards.

In sum, you should target the down payment at a notch point, credit card utilization ratios below 50% on 5 or fewer cards, and perhaps total debt service payments below 8% of your cross income. Allocate to the cards first, down payments second, because it takes awhile for credit scores to adjust fully.

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