September 4, 2001
"We
plan to sell our condo and buy a house. We
expect to get enough money from the proceeds (after commissions, closing costs,
etc.) to pay off our debts, or make a down payment, but we can't do both.
Which will allow us to buy the most house?�
It
depends. Debt
is one of the factors used to assess the adequacy of your income, and it also
affects your credit score. If
the minimum monthly payments on your credit cards and all other debt exceed 8%
of your gross income, or if you have a fistful of credit cards that are �maxed-out�,
paying down debt might increase your house-buying capacity.
But you can�t know for sure until you get well into the loan
qualification process.
Lenders
usually assess the adequacy of borrower income with two ratios. The
"housing expense ratio" is the proposed monthly mortgage payment,
including mortgage insurance, property taxes and hazard insurance, divided by
the borrower's gross monthly income. The "total expense ratio" is the
same but expenses include the borrower's existing debt service obligations. For
each loan program, lenders set a maximum housing expense ratio, such as 28%, and
a maximum total expense ratio such as 36%.
While
the maximums may vary from one type of loan to another, or with other features
of the transaction, usually the total expense maximum is 8% above the housing
expense maximum. This means that if
your monthly debt payments are less than 8% of your income, debt will probably
not be a limiting factor on how much of a loan you can afford.
Even
if monthly debt payments exceed 8% of income, debt will not be a limiting factor
if your total expense ratio is below the maximum.
For example, if the maximums are 28% and 36%, and your ratios are 24% and
34%, debt is not a limiting factor even though debt service payments are 10% of
income.
You
can calculate your debt service payments as a percent of income now.
You can�t calculate your total expense ratio because that requires
knowledge of the loan amount and interest rate.
However, you can use the affordability calculator on my web site to
experiment with hypothetical numbers. That
should give you a feel for the likelihood that your current debt service will
limit the amount you can borrow.
Debt
also affects credit scores. Credit
score may affect house-purchasing capacity by affecting the interest rate, the
required down payment, or both.
Your
ability to improve your credit score by paying down debt, however, is limited.
If you have a history of payment delinquencies, repaying the accounts
that have been delinquent will not raise your score.
A poor payment history can be neutralized only by a good payment history,
and that takes time.
You
may be able to improve your credit scores modestly if you have many accounts,
and the balances are at or close to the maximums.
While the scoring rules are not fully known, you can probably increase
your credit score by paying off bankcards in excess of 4, and reduce the
balances of the cards remaining -- 75% of the maximums might suffice, 50% would
be even better.
Whether
or not an increase in credit score will increase your house purchase capacity
depends on what your score would be with and without debt repayment.
Lenders commonly stipulate minimum scores for different classes of risk.
For example, they may set 660 as the minimum for an �A-rated�
borrower. If you have a score of
650 with 8 bankcards, paying off 4 of them might raise your score above 660.
But if your current score is 690, you are already an A-borrower, and if
it is 620 you probably can�t get to 660 by repaying balances.
The
circumstances under which debt repayment will increase house-purchase capacity
are thus very �iffy�. It is
going to be difficult to pin them down until you go through the process of
qualifying for the loan needed to buy a property at some price.
That�s why someone in your position needs a skilled professional to
guide them through the process.
Copyright
Jack Guttentag 2002
