When it comes to debt, we each tend to think of different types of debt in different ways. For example, you may feel “normal” for having an auto loan but ashamed of having credit card debt. So what about real estate? People purchase real estate — either as a home to live in or as a way to earn extra income. Either way, I think it’s safe to say that most look at it as “good” debt — either out of necessity (the cost of a home makes it nearly impossible for anyone to purchase one in cash) or simply because it’s so common.
Since the housing bubble burst, it may be time to rethink whether real estate can always be considered “good” debt. Like anything else, the answer to this depends on where you are financially and what you can afford to take on. Below are a few points to help you make a decision that’s right for you.
First off, let’s go through a few questions:
How Will You Pay?
This is more important than you may realize. The way you choose to pay will have a direct and large impact on everything to follow. To start off, if there’s any way at all you can pay for the property in cash, then you may want to do that. Any time you can avoid losing money to interest then that’s something to take very seriously. Of course, you may not have enough money to pay in cash, or you may not want to drain your savings account if you do. If either is the case, consider your down payment. The larger your down payment (20% is considered very good), the lower your monthly mortgage payment will be (as well as the lower principle balance). And while someone may offer you credit for little to no down payment, this will cost you more in interest in the long run. Higher mortgage payments leave you less income to save and to meet basic needs.
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Do you know your credit score? Now’s the time to find out what it is and do everything in your power to raise it before you obtain a new mortgage. This includes disputing any errors and paying off whatever debt you can. The score you have when you apply will determine exactly how much you can borrow and at what interest rate. If your score needs a lot of work, then you are probably better off spending your time and resources building that first. Remember, if you’re going to take out a 30-year loan on a property, it’s worth waiting a year or two to get a lower interest rate. A change in interest rate can cost — or save — you thousands of dollars during the life of your loan. First, you have to understand your credit report. As you work on building your credit, you can check your progress by obtaining your credit score every month. There are many free options, among them is Credit.com’s Credit Report Card.
How Will This Affect Your Debt-to-Income Ratio?
How much money do you earn and how much money do you owe? This is very important to consider both when applying for new loans and when simply evaluating your financial health. It’s best to stay at or under 30% — so take a look at what your new payments will be and compare them to what you take home. If the number hovers at 50% or above, you may not be in the best financial health to purchase a new home. Remember that real estate comes with many other costs like taxes, eventual repairs, maintenance and so on. So if there’s little to no extra room in your budget for these costs, purchasing a home could really put you in hot water later.
If you’ve answered these questions and decided to move forward with purchasing real estate as an investment, let’s just take one more look at how it can affect your credit score.
[Related Article: Why You Can't Get a Home Loan]
How It Can Hurt
There are many ways a mortgage can hurt your credit score. Making late payments is the number one way to damage your score. If you have a high debt-to-income ratio, that may also translate to a dependency on credit cards that leaves you with high revolving balances — this also has a negative impact on your score. The number one thing to consider isn’t just the amount of money you’re making now, but the likelihood that your job is secure and that the income is reliable — and also make sure you understand the difference between a fixed rate and a variable rate. The variable rate may seem low now, but if you budget your mortgage based on that, you’re at a high risk of not being able to make your payments if and when the rate goes up. No matter what, determine your risk of not being able to make payments before taking the plunge.
How It Can Help
There are ways that a mortgage can help your credit score — especially if you make timely payments. Having a history with a financial institution does have a positive effect on your credit score, but only if you make payments on time, every time. Want to pay off this debt even faster? You could sign up for biweekly payments rather than make one monthly payment. This splits your monthly payment in two and equals one extra payment each year while having little effect on your monthly budget. In other words, you’ll save money on interest payments, lower the life of your loan, and ensure that you don’t have late payments on your credit report.
It comes down to this — there’s no such thing as a good debt or bad debt. It all depends on the timing in your life. Are you ready for the payments, will you be able to afford the payments in the years to come, and do you have contingency plans set up to prevent potential financial disaster? Explore everything that can go wrong and what you’re prepared for so you can make a decision that you won’t come to regret. And remember, a no doesn’t last forever — it could mean “Not now”! If you determine you’re not ready, then take the steps to get yourself there so you can accomplish your dream of homeownership.
[Free Resource: Check your credit score and report card for free with Credit.com]
Image: woodleywonderworks, via Flickr