Mortgage Confidential: When and when NOT to pay down debt

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Mortgage expert David Reed invites Walletpop readers to ask him questions about real estate financing. leave your questions in the comment section of this post.

Okay, I admit. There are those who will vehemently disagree with the premise of not paying down debt, I'm among them, but there are times when not paying down debt makes perfect sense when considering buying real estate and obtaining a mortgage. On the other side of that very same coin, it also makes sense to pay down debt for the very same reason: to help qualify for a home loan. What's up with that?

When debt-to-income ratios are too high for a particular loan program, then getting rid of some of that debt to help qualify is in order. But which debt? Revolving balances on credit cards do very little unless you substantially pay down a credit card balance, from say $10,000 to $5,000, but simply paying $1,000 or so will do very little to reduce the minimum monthly payment on that revolving account. That means the debt to income ratio will barely be affected.

Not the case with installment loans, and in particular an automobile loan. An interesting underwriting guideline asks that if an automobile loan has less than 10 months remaining then the lender won't count the car loan against the borrower's debt even if the borrower is still making payments on the car. For instance, if a borrower's monthly car payment is $450 and has 12 months left, the borrower need only pay the note down to nine payments. That's $1,350 to pay down the auto loan instead of paying off the auto loan completely, somewhere around $5,500. (this trick doesn't work on a leased vehicle, the underwriter will assume that when the lease is over the borrower will have to buy/lease another automobile, keeping a similar debt load.)

A quirk regarding not paying off debt addresses credit scores. One of the biggest factors when calculating credit scores is the loan balance compared to available credit. The magic percentage seems to be somewhere around 33%, meaning a better credit score will be calculated with $3,333 in loan balances with a $10,000 credit limit compared to a $10,000 credit limit with zero balances. I know it sounds counter-intuitive, but having a zero balance on a credit card can actually lower a credit score compared to a loan balance of about a third of the credit line.

Real estate finance expert David Reed is president of CD REED Mortgage Bankers in Austin, TX and author of Mortgage Confidential: What You Need to Know That Your Lender Won't Tell You and Mortgages 101: Quick Answers to over 250 Critical Questions About Your Home Loan.

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