Pay Off Debt or Save?
A common question I see on message boards and blogs concerns saving versus paying off debt. This is of particular importance when the savings is being used as a down payment on a home purchase.
With low returns on savings and high borrowing costs it would seem on its face to be an easy question to answer - pay off the debt. But with uncertain economic times, it feels safer and therefore smarter to keep a stockpile of cash.
Let’s take a look at it from a mortgage perspective. I put together the following scenario that really hammers home the importance of debt reduction in comparison to down payments. The loan scenario is an FHA loan purchase with 3% down. The borrowers have a lot of consumer debt together and have enough extra money to pay off a car costing them $300 per month.
As it stands, their debt to income ratio is too high to qualify for the program they’re being put into. With $8800 that could be paid towards the auto, we apply it to the down payment in the next image.
Because this is an FHA loan, there is no rate improvement to putting down more money. The monthly payment drops by almost $50 because of the lower loan amount, but the DTI ratios are still too high…above 50%.
We could apply the saved money towards the credit cards, but the balances are so high, a large payment wouldn’t decrease the monthly as much as the auto loan. So let’s pay off that car!
A couple things happen here when the car gets paid off. First of all that DTI ratio plummets to 46.5%, well within the range of this particular loan program. Secondly, while the mortgage payment goes up $50, the couple’s cash flow is improved by $250 per month allowing more freedom to save or pay off their other monthly debt.
It’s important to remember that having a small emergency fund is always good to have and if you buy a home you wouldn’t want to dip below six months of expenses in reserve for unexpected home or auto repairs, job loss or sickness. My point here is to show you how beneficial paying down debt is in comparison to saving for a down payment.