Starting the journey of buying your first home can be exciting but also overwhelming, especially when thinking whether it’s best to pay off existing debt first.
For those buying a home for the first time, handling existing debts is a big step that can greatly affect your financial stability and chances of getting a mortgage.
High debt can lower your credit score and increase your debt-to-income ratio (DTI), both of which are important factors lenders look at during a mortgage application.
By paying off your debts before taking on a mortgage, you can boost your credit score as well as your deposit, while making yourself more appealing to lenders – which can go a long way to getting better loan terms and interest rates.
Impact on Your Credit Score
Your credit score is a key factor that lenders check during a mortgage application. Multiple applications for short term debts like personal loans, car loans or credit cards, can lower your score and are not looked favourably upon by lenders.
If you can reduce your debt and close off any loans and credit cards, this will help to raise your score and show that you are financially responsible. This better score can make you more attractive to lenders, offering you better loan terms and interest rates.
Debt-to-Income Ratio
Understanding the debt-to-income ratio (DTI) is important when planning to pay off debts before buying a home.
The DTI ratio measures the percentage of your income that goes toward paying your debts. Lenders use this ratio to see how risky it is to lend to you.
DTIs are calculated by dividing your total debts by your gross annual income (before tax) to give you a ratio number. A high DTI ratio means a big part of your income goes towards debt repayments, which can make it harder for you to manage extra costs – like a mortgage.
Conversely, a lower DTI ratio means you have a healthier financial situation, making you more appealing to lenders.
Lowering your DTI ratio by paying off debts can boost your chances of getting the most out of your borrowing power and more favourable mortgage terms. As a Mortgage Adviser, I can help calculate your DTI ratio for you.
Improve Savings for Your Home Deposit
Clearing debts before buying a home can greatly enhance your ability to save for a deposit.
When you’re not weighed down by high monthly debt payments, you have extra money to save for your home buying goal.
A bigger deposit, not only reduces the amount you need to borrow, but also lowers your loan-to-value ratio (LVR). This can help you get better mortgage rates and terms.
Additionally, a larger deposit can cut the need for a Low Equity Premium (LEP), which is often required if your deposit is less than 20% of the home’s purchase price.
By focusing on paying off debts and building your savings, you create a more favourable financial profile.
This dual approach can improve your chances of getting a mortgage with good terms, making your dream of homeownership more achievable.
Steps to Help Clear Your Debts – Snowball or Avalanche Method?
The “avalanche method” involves paying down high-interest debts first. These debts, often in the form of credit card balances or personal loans, can quickly pile up because of high interest rates, making them harder to manage over time.
Alternatively some people prefer the “snowball method”, which involves paying off your smallest debt first then rolling the money used to pay off the smallest balance to the next debt on your list. The amount continues to “snowball” and gets larger and larger so you can really start to make a dent in clearing your debts.
Whichever way you decide to go, as your debts start to shrink quickly, you’ll start to see a positive impact on your credit score, making you more appealing to mortgage lenders.
What About Your Student Loan?
When it comes to mortgage applications, the banks will treat your student loan as a liability until it’s paid off.
Even though student loans are essentially interest free, the repayments are actually based on your income – not the loan amount. So the more you earn, the higher your student loan repayments will be.
Since a student loan is looked at as a liability by the banks, it will reduce the amount you can borrow for a home loan.
To overcome this, you could look to make extra payments on your student loan to get rid of it quicker – check out the IRD Student Loan repayment calculator to see how additional repayments can reduce your student loan faster.
Benefits of Working with a Mortgage Adviser
One of the big advantages of working with a Mortgage Adviser is getting access to personalised financial strategies.
We don’t offer a one-size-fits-all solution; we take the time to look at your unique financial situation, goals, and challenges to create a custom plan.
For example, if you’re struggling with a high debt-to-income ratio or a low credit score, I can recommend specific actions to improve these areas.
This might include prioritising certain debts for repayment, consolidating loans, or advising on how to build up your savings for a bigger deposit.
By providing personalised advice and strategic planning, I’ll help you navigate the complexities of the home buying process more effectively, increasing your chances of getting a mortgage that suits your needs and sets you on a path to successful homeownership – so reach out if you need a hand!
Applications for finance are subject to meeting the lenders criteria, terms, and conditions. Refer to our website www.hbmi.co.nz for our Public Disclosure Document.
