Should I Pay Off my Debt or Save Up for a Down Payment on a House?

(May 1st, 2007)

Dear 3DebtConsolidation.com:

My spouse and myself are working very hard to pay off our current credit card debt by atleast 80% and then build up a good solid down payment for the purchase of our first home. We currently owe over $25,000 in credit card debt, student loans and auto loan debt. My question to you is, should we focus on paying off this big debt first before buying our house, or should we just make the minimum monthly payments on the debt and build up a larger down payment? Currently, we have saved up about $25,000 for the down payment on our house. The house we plan to purchase is valued at $275,000. I want to avoid having to pay Private Mortgage Insurance and build up a down payment of atleast 20% (which is equal to $275,000 x 20% = $55,000).

Dear Mindy:

You have to balance out between saving for the initial mortgage down payment and paying off your $25,000 debt. You should probably focus on paying off the $25,000 debt as soon as possible, before purchasing a home. For example, consider your following situation:

You and your spouse have an after-tax monthly take home pay of $5000. After paying off all the necessary expenses every month (including rent, groceries, utilities, student loan payments, car loan payments, entertainment expenses, etc), you have $1000 to save. Take a 5 year time horizon:

Scenario i) We assume you are paying 14% Annual Percentage Rate (APR) interest charge on your $25000 debt. Here is the amortization schedule assuming a fixed payment schedule. Your payment towards your debt is $625 / month and your savings every month equal $1000 - $625 = $375.

The result? In 55 months (approximately 4.5 years), you will have fully paid off your $25,000 debt and would have $20,625 saved up. This is not too bad considering you are saving only $1000 per month.

Scenario ii) We will assume you are paying 14% Annual Percentage Rate (APR) interest charge on your $25000 debt. Here is the amortization schedule assuming a fixed payment schedule. Your payment towards your debt is $1000 / month and your savings every month equal $1000 - $1000 = $0.

The result? In 55 months (approximately 4.5 years), you will have fully paid off your $25,000 debt and would have $25,000 saved up. This is MUCH better than the $20,625 you saved up in Scenario #1. Furthermore, you will have paid a lot less interest in Scenario #2 ($4,731.15) as opposed to paying $8,872.4 in interest charges in Scenario #2.

So Mindy, in your situation, I would recommend you allocate the whole $1000 savings every month to pay off your $25,000 debt in a 30 months period. After that, you can save the entire $1000 per month and not have any debt to pay off. Ofcourse we do not factor in things such as cost of living increases, loss of job, etc into this equation, but this should give you a good idea.