This article explores some of the ways that paying off debt can impact your life. The elimination of debt can have both positive or negative impacts on your credit score, which could effect your ability to qualify for a mortgage. Paying off debt could positively or negatively impact your quality of life, depending on your goals and financial situation. Paying off debt could save or cost you money over time depending on the size and type of debt. It is important to have clear goals and intentions when eliminating debt and to take into account potential effects.
by Christian Scully
Paying off debt should definitely be a goal of anyone seeking to live what we consider to be a better life. Being financially free from creditors, not having monthly payments to worry about, and having the ability to save and invest more of our hard earned income should be everyone's goal. The idea that we forever have to have some sort of debt bill, we have to owe somebody money just to live a decent life is engrained in our society. When the Diners Club card was first offered in 1950, it began a shift in the culture's view of money and lifestyle aspirations. It was easier to appear rich as opposed to slowly build wealth over a lifetime. Those who remained frugal, bootstrapped small businesses, bought goods with money they had and invested any budget surplus managed to grow wealth enough to live incredible lives with generational financial security.
When our mindset shift occurred and we began our debt-free journey to financial freedom, we were only focused on the main goal: pay off all debts as fast as possible. We didn't have a target date in mind, but I had long held a personal goal of not having children while in debt. Not having the financial strain of debt interfering with family life and raising children was number one on my list of reasons to be debt free. We used this as a starting point, but over the next couple years we learned about the different types and effects of debt and how we could find a balance to reach our goals and not put our lives on hold.
I think there are two basic things to keep in mind from the start. First, when making any plan for the near or distant future, make a list of what you are hoping to achieve. What is the ideal result? What is the end goal? Then second and most important: fully expect those goals and the plan to morph over time. In fact it is super important that it does. Things come up, events happen, opportunities arise, markets change. Keep your eye on your goals, re-evaluate your list of goals regularly to make sure the targets don't need to be adjusted, and then shift and alter strategies as new opportunities or roadblocks come up. Once you have your goals targeted, consider the following ways paying off debt can effect you:
Paying off debt could potentially help or hurt your chances of qualifying for a mortgage.
There are two parts where debt comes into play when applying for a mortgage. The first part is your debt-to-income (DTI) ratio. This is a metric all lenders use to judge your ability to pay. For most borrowers this ratio will need to be 50% or less. Your DTI is calculated on a monthly basis: your total monthly debt payments (including the new monthly mortgage payment you are applying for) divided by your total gross monthly income ("gross" means before taxes are taken out). The higher your DTI ratio, the lower the mortgage loan amount you will qualify for. So paying off monthly debts can help you qualify for a mortgage.
The second part where paying down debt comes into play is your credit score. Credit scores are always a thing of mystery and are notoriously confusing. Don't ever feel bad for not understanding how credit scores work, or what makes scores go up and down. It often is illogical. One common illogical scenario is when paying off a monthly debt actually makes a credit score go down. Yes, this can happen. However, having too much of your available credit utilized can also keep your credit score low. If you are applying for a mortgage, the best advice is to speak with a licensed mortgage loan originator. In the pre-qualification process the loan officer will pull your credit report. From there they can assess if your credit is too low, or is just under a threshold that would qualify for a lower interest rate. They should be able to run a credit simulation to test what potentially would happen if you paid off certain debts. If you are applying for a mortgage, don't pay off any debts before speaking to a licensed mortgage loan originator to determine how it would affect your loan application.
If you are applying for a mortgage, any excess funds might be more needed for a down payment and closing costs.
Without going through the prequalification process with a lender, you won't know for sure where you are at. If your credit score is fair to decent, and you have some funds for a down payment, you may already be close to qualifying for a home loan. Paying down your extra debt might not actually affect your qualification, or not as much as you think. It may potentially be more important that you save any extra funds for a down payment or closing costs. Again, speak with a loan officer to learn more. Not sure how much closing costs are? Find out here. Want to learn about the prequalification process? Read this article.
Paying off debt can potentially increase or decrease your quality of life.
This idea is fairly simple. If paying off debt lowers your monthly expenses, it will ease your financial worries a relative amount and likely will make additional funds available to invest for retirement or save for a property down payment. However, if you pay off debt without first saving some money in an emergency fund, then you could find yourself in dire straights should an unexpected situation arise. Don't pay off debt until you have at least a few month's worth of expenses saved up in a cash account. Dave Ramsey suggests $1,000, probably because his audience is all over the country and in some parts $1,000 can go a long way. Where we live in the Northeast, $1,000 doesn't go very far. You will feel a lot more comfortable knowing you are prepared for challenging times, when you start aggressively paying off debt if that is your goal.
Paying off debt can potentially save or cost you money.
This is another simple concept. Keeping this idea in mind on a monthly basis has really changed how we view debt. The debt we carry is from the past. There is nothing we can do to change the fact that we borrowed money and now need to pay it back. However, you'll want to consider your goals when deciding whether or not to aggressively pay off your debt. Paying off a high-interest credit card will definitely only save you money in the future. That should be top-priority. However, paying off a car loan with a 3% interest rate could be the right or wrong decision based on your priorities. If you need to reduce your DTI and the car loan is the only option, then consider paying it off. If your top priority is the peace of mind that being debt-free brings, then consider paying off the car loan. But if your top priority is maximizing your earned income and growing your investment account, then paying off the car loan may not be the best choice. If you invest in a low cost index fund (we love Betterment), you should be able to earn 6% or more depending on your portfolio balance (we have averaged 10% returns since 2016). That means you can earn more money by keeping your car loan at 3%. Instead of sending all your money to the creditor, invest it safely and grow your funds more than you are paying on the loan. This concept applies to all debt. We recently refinanced Brittany's student loan through Earnest at 3.36% interest. For now, we will continue making minimum monthly payments and invest any extra funds we have. We will end up earning more with the investments than we would have saved paying off the loan. You can do the math for each of your own scenarios and weigh the pros and cons I've discussed here.
+ Better Tip
If you are applying for a mortgage, don't pay off any debts before speaking to a licensed mortgage loan originator to determine how it would affect your loan application. The loan officer should be checking your qualifications in your current financial position, and then make recommendations based on those findings. You don't want to take a chance and accidentally drop your credit score below an important threshold like 700, by paying off a $1,000 debt. Credit scores are totally strange. It is possible it could make more sense for you to put your debt repayment plan on hold until after you close on your new mortgage. This goes for purchases and refinances.