Do I need to pay off debts before refinancing?

Posted by  on Apr 06, 2013

There are many reasons paying off credit card debt is wise, but before you rush to reduce your credit card balance, consider the other factors that can influence whether your mortgage refinance is approved. A refinance approval will depend on your home's appraised value, your credit profile, your income and assets, and your employment history.

Credit card debt plays into two factors that affect loan approval:

  • Your credit score. According to FICO, your use of credit is one of the most important factors in determining your credit score. If you cannot pay off all your credit card debt at once, your best strategy to improve your credit score is to pay down the balance on each card to less than 25 to 30 percent of the credit limit. Financially, it may seem better to get a zero balance transfer and put all your debt on one card with no interest, but this move could actually damage your credit score.
  • Your debt-to-income ratio. Your debt-to-income ratio factors in the minimum monthly payment on all of your debt compared to your gross monthly income. If your credit card bills are high or you have student loans or a costly car loan, this could make your ratio too high for a loan approval. Lenders have varied standards for the debt-to-income ratio, but most lenders prefer a maximum ratio of 41 to 43 percent.

To pay or not to pay?

Your decision to pay off credit card debt before you apply for a mortgage refinance depends on your overall financial plan. For example, you may not want to pay down your credit card bill under these circumstances:

  • If you are refinancing to lower your monthly payments and ease cash flow, you may want to use your savings after the refinance to pay off debt more quickly.
  • If you have low cash reserves, you may need to keep what you have in the bank. Lenders often require cash in the bank that would cover your mortgage payment for two months or more if you have an emergency before they will approve a refinance.
  • You intend to pay your closing costs with cash because your loan-to-value is high and you don't want to add the costs to your principal balance.

On the other hand, you probably should pay off some or all of your debt in these cases:

  • Your credit score is under 680 or 700. An FHA refinance may be an option, but most conventional lenders want your credit score to be higher, particularly if your debt-to-income ratio is high or you don't have a lot of equity in your home.
  • Your debt-to-income ratio is above 43 percent. Most lenders won't approve a loan above that rate.
  • You want to switch to a shorter loan term. Even with lower interest rates, your monthly payments will likely rise if you reduce your term to 15 years from a 30-year loan.

Discuss any thoughts about paying off debt with a lender, and make your debt reduction plans fit the context of current mortgage rates, because a lender can use multiple calculations to determine your best solution.

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