Should I devote my money towards future down payment or reduce DTI ratio?

6 Replies

I am currently in the learning and research phase of REI and I was wondering which option would be more prudent. I plan on buying either a multifamily or a SFH (to live then rent) later on this year and I hope to use the FHA loan to finance the property. As it stands right now I have about ~20k worth of debt (car, school). I want to get rid of this as soon as possible, but I really don't want it to come at the expense of me waiting even longer to get my feet wet in the REI game. I figure I can either focus more on getting my debt down so I can have a wider variety of properties to choose from, or I can. Set money to the side and use that to make a sizeable down payment. Any suggestions? Thanks for reading.

Personally I think you need to balance risk/reward. Leverage is Risk, so you don't want to "leverage to the hills" if you want to reduce some risk. My opinion is a good balance, so paying down properties some, but always keeping a % financed based on your situation to keep your ROI high (think rule of 72). I think having about 40% equity and 60% debt is a good target.

You'll hear split views on this topic. I was in this same situation 5 months ago- good amount of graduate school debt and questioning whether I should use savings towards that or primary residence. I bought an FHA home for 127k, spent about 8k on closing and downpayment, then put 18k into remodeling. I believe it was the smartest thing I could do in my opinion. Between the remodel and local appreciation the value is closer to 150k. Soon enough I may decide to pull some money out for either an investment property and/or pay off some debt with it. I plan to hold onto the property, rent it out, and purchase another primary residence in a year or two. Buying my house is what led me to want to start investing.

By purchasing this home I jump started my real estate interests, learned how to manage a remodel, built a network of contractors/agents/mortgage brokers/title company, and have a place of my own. Dave Ramsey would scoff at my decisions but believe it was the best thing for me and my family.

John,

If your debt-to-income ratio prevents you from securing financing, you'll have no choice but to reduce your outstanding debt. However, if you qualify for a loan now, and have funds for the required downpayment, I would suggest you get into a property. This way you can convert the money your currently spending on rent into a built in saving plan by building equity. If you buy a mult-family home, your tenant will probably pay a substantial part of your mortgage, thereby reducing your cost of living and increase your free cash flow. Free cash is what will allow you to work towards saving for another downpayment on a new property, or accelerating repayment of debt.

Keep in mind, that if your debt is manageable and the after tax cost of the borrowed money is low, you will probably find better returns by using free cash to build up cash for downpayments on additional properties. Just be sure you maintain sufficient cash reserves (liquidity) for any unaticipated interruptions to your cashflow, i.e. loss of income from your primary occupation or vacancies.

All companies and investors looking to grow will have to find financing to grow their business. very few companies or individuals generate enough free cash to fund expansion using internal funds. Don't be afraid of debt, just manage it by getting the best rates and maintain sufficient working capital. Thus, you should be fine.

Paul, CPA and real estate investor

Thanks for all the responses.

@Dennis Kolsch how did you finance the remodel if you don't mind me asking?

@Paul DeRousseau I can get financing but I fear that my DTI may limit the type of property I may be able to purchase. Although I have heard some critiques of this method, I plan on drawing money from my jobs retirement plan (TSP) to make my down payment.

If your taking the money out from you TSP for the purpose of buying your first home and you plan to occupy the property, you should be able to do so without incurring any penalties. 401(k)s and 403(b)s generally allow for this (check with your plan first). In this case, I find no fault with tapping this resource.

However, if your planning on withdrawing the money to purchase an investment property, there may be a significant penalty and tax consequence. Thereby, making it very expensive capital to use. If that is the case, I would highly recommend you reconsider. The high cost of using those funds may negate the returns you achieve in your real estate investment. I would try to find an alternative source of funding for your investment.

Start working with a lender and find out what their requirements are for obtaining a mortgage. You may find you don't need as large of a downpayment as you think. If you can't qualify right now with the amount you have available to for a downpayment (without taping your retirement funds), a good mortgage lender can at least provide you with a roadmap to get where you want to go. And that's what you need - a gameplan!

Malik,

I used half cash and half 0% interest credit card for the remodel. I have 15months to pay it off, so I've budgeted about $800 monthly toward it to knock it out. This is all based on my subjective experience and intuition, but the biggest questions I asked myself in deciding how wise it was to take on more debt when I already have debt were:

1). Is taking on additional debt going to help me achieve my long-term financial goals sooner?

2). Do I have enough monthly cash flow and cash reserves to comfortably (i.e. without too much worry or stress) take on the new debt?

In sum, I believed it would jump start my financial goals and I felt comfortable enough to take on both the new mortgage payment, new cc debt, and previous debt. FHA guidelines somewhat prevents you from making a horrible mistake, so assuming the home passes the appraisal and you qualify for a loan you can at least rest in knowing you should be okay financially. Again, Dave Ramsey would hate my thinking but whatever.

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