Pay Off Credit Cards and Loans or Save for a Mortgage?

I recently received the following email from a reader:

I have what I think might be an interesting topic, one that I am struggling with currently.

Is it better to pay down debt (credit cards, car loans) to $0.00 or close to it, or concentrate more on saving for a down payment?

I have my thoughts, but wouldn't mind hearing from more experienced people on it.

There you go -- have at it. Give us your advice.

Comments

[jake]

Remember to factor into your decision how much harder it will be to pay off your existing debt once you are making a mortgage payment. You could end up paying those high interest rates for years longer than necessary.

[J at Home Finance Freedom]

Rule #1: Pay off debt first. Arbitrage and tax-subsidy opportunities are less common and less beneficial than many people think. Even if you wanted to time the market, the current housing market is hardly an argument to buy soon and meanwhile the Federal Reserve is hardly in a rate-cutting mood.

[plonkee]

Is this a trick question?

Unless the debt at an interest rate lower than 4.5% (or so) you should pay down debt. If its lower than that you could stick your extra money in savings until you've got enough to pay off the whole balance.

I guess that because home ownership is perceived as a route to wealth people might want to buy a house, but if you look at the overall picture, regardless of what you do, you are at -$X at the moment and you want to get to +$Y where X is the amount of your debt and Y is the amount required for a house purchase, so you need to generate $X+Y. It'll almost certainly be quicker to do that if you pay off your debt first.

[EMF]

Pay off those high interest rate credit cards first. This will lower your monthly credit payments, which will also improve your chances of qualifying for the mortgage. When I anticipated buying the house I'm living in, I went ahead and paid off a consumer loan that was close to being paid off anyway, but didn't pay off my car loan, which had longer to go and was at a lower rate anyway.

[bettis]

i have so many friends in this same position with student loan debt. in speaking with them, i often hear the "as long as the return on investment of the money i am saving is greater than the interest i am paying on my loans, i should not pay off the loans." argument.

logically, this argument makes sense...well, it makes cents. considering strictly the numbers, it would be a proper decision. however, as most of us have experienced, there is a huge variable that is often not discussed. that is the variable of risk. when the cars break down and the kids need surgery, the small sum of money you would gain by delaying your debt is quickly negated. you find yourself over exposed and standing on the edge of broke.

as far as the proposed question, based on the same principle, i vote to pay off the debt.

[Patrick]

I agree with everyone else so far. Unless the interest rates on your debt is less than you will get in a 'guaranteed' savings account or other investment, it is better to pay down your debts first.

You will end up paying a lot less money in the long run - on your debts because you will not pay as much interest, and most likely on your mortgage as you should be able to qualify for a better mortgage rate with better credit.

[Dus10]

One thing that everyone tends to ignore when purchasing a house is the time-value of money. When you finance a home that you purchase in today's dollar at a low interest rate, you are going to pay it off with future dollars, at the same nominal value you pay today. This means that your payments actually go down over time. So, for those people are into the big "renting is better than owning, for today," it really isn't, unless you are only going to stay in the home for a very short amount of time.

On the other hand, if you reduce your debt prior to purchasing, it will be easier to afford your home, and you will likely qualify for a better rate, because you will have lower debt-to-income and a higher credit score (hopefully).

[Easychange]

The first issue is simple numbers. From a numbers standpoint, the debt on credit cards is likely more than could be earned by saving in an absolutely secure account like a money market at 5%. Most people that I know don't have this as a rate on all of their cards.

But even if you did, you would earn 5%, but you would have to pay taxes on that income which would likely bring it down to about 3 or maybe 4% gain.

Furthermore, saved money in general doesn't really help your credit score. So, if you are someone who has amazing credit, that is one thing, but most people don't. And keeping that debt around for any longer than is necessary is going to hurt your fico score and thus make your mortgage more expensive.

So great, you've managed to save more money and make 3% in a money market on your savings, but now you are stuck paying an extra .25 or .5% on your 30 year fixed mortgage because your fico score is not as great as it could be since your credit card balances are high. (You DID get a 30 year fixed mortgage right?) And assuming that you did that, you will still be spending an extra 6,250 dollars per year on a 250000 balance in a mortgage. That is probably much more than your debt.

Bottom line, just pay off the debt. You'll save much more on car loans, home loans, etc than you would gain by keeping the money in a savings or money market account, and with a lot less effort.

[FamilyFinanceBlog]

I think everyone makes some very good points. I agree that credit card debt should always be paid down. I'm not 100% sure about the car loan debt and student loan debt, though ... perhaps those who have thought it out more can chime in.

If you make the assumption (not necessarily true, but let's assume) that housing prices are going to go up by 5% a year for the next 5 years and that interest rates will go up by 2% in the next 5 years, but your salary is only going up by 2-3% per year, how would that affect your decision? You're able to afford more home today than you will in 5 years if all you do is pay off your debt now instead of using your money for a down payment now. And your house payment in 5 years will be a much smaller fraction of your income than it is now. It's these types of what if's that make the decisions a lot more difficult in my opinion.

[Ciji]

Pay the debts, DON'T go closing all the accounts!!! What about your CREDIT SCORE? I agree that you should pay off an many debts as possible, but be cautious when you go about closing accounts. Oftentimes, if you pay a debt then close the account, it can affect your score negatively. And then it won't matter how much cash you have when you shop for a mortgage because your options will be limited because of a low FICO score. I made the mistake of paying off many credit cards and then closing the accounts, and my score DROPPED!

The way credit works (and this is a basic explanation) is that the number of open and positive debts you have is weighed against the number of closed & negative debts. Sometimes it beneficial to have open account sin good standing rather than a bunch of closed accounts, even if said closed accounts were paid on time and in full. You really need to pull all your credit reports and figure out how to have more positive open lines of credit than negative ones, while reducing the amount of credit you have extended to you by just enough to appear to be a responsible person but not by too much so it looks like you are risk. Go to www.myfico.com for more expert info.

[Ciji]

Pay the debts, DON'T go closing all the accounts!!! What about your CREDIT SCORE? I agree that you should pay off an many debts as possible, but be cautious when you go about closing accounts. Oftentimes, if you pay a debt then close the account, it can affect your score negatively. And then it won't matter how much cash you have when you shop for a mortgage because your options will be limited because of a low FICO score. I made the mistake of paying off many credit cards and then closing the accounts, and my score DROPPED!

The way credit works (and this is a basic explanation) is that the number of open and positive debts you have is weighed against the number of closed & negative debts. Sometimes it beneficial to have open account sin good standing rather than a bunch of closed accounts, even if said closed accounts were paid on time and in full. You really need to pull all your credit reports and figure out how to have more positive open lines of credit than negative ones, while reducing the amount of credit you have extended to you by just enough to appear to be a responsible person but not by too much so it looks like you are risk. Go to www.myfico.com for more expert info.

[Moneymonk]

Common Sense... pay down debts first! You may not want to be at 0 balance, But get the debt less than 30% of the balance. That way your debt to income ratio will be low. And then start saving for whatever!

[robdollars]

ahh, the all glorified fico. this whole dicussion is not a matter of numbers, debt, statistics, etc. it is a behavioral problem. i hate to be the first to mention this bluntly, but you are broke. you owe a lot more than you have at most likely high interest(like most americans) you need to change the patterns in your life to actually accumulate real wealth. [hopefully the student loans were a good "investment" towards your future career] so should someone who is broke go buy a house. no. clean up the mess first. then you will get a better loan, and be moving forward instead dragging your debts with you. alot of times people throw numbers out to make themselves feel smart (and some people are, but most aren't.) you simply get rid of the debt now when you have the cheapest cost of living you will ever experience until you are sixty. if you find that you lack the finicial discipline to pay off the debt, just imagine what it would be like with a huge mortgage? anyway, you don't have to have a fico score to get a loan. it is called a "manual overwrite" most crediable mortgage companies can do this. all you need is the money for the down payment sitting where they can see it (again the whole "not being broke thing") and a paycheck stub, possibly a letter from your employer and you get a real mortgage at regular interest rates. you will be amazed at what a bank/mortgage company will do for a customer who ACTUALLY HAS MONEY.

[Rob]

Definitely pay off the debt first. If you can't pay it off immediately, it would be wise to save some money too (for an emergency fund as well as towards a mortgage).

If your debt is school loans at low interest rates (say under 5%), I wouldn't worry about them as much as credit card debt and car payments.