“Should we pay off our credit cards before saving for a down payment? Or is there a point where it makes sense to make the minimum payments on our cards and bank the rest for a down payment?”

Credit cards play a complicated role in preparation for a home purchase. On the positive side, a history of timely payments on credit cards builds a positive credit history and a correspondingly high credit score. That’s an important plus when you enter the home loan market.

On the other hand, if there are any indications of financial stress in your credit-card history, it will reduce your credit score, even though you may be making all payments on time. Indications of stress include new card issuances and high utilization ratios — these are the ratios of balances to maximum balances. As you plan ahead for a home purchase, get your utilization ratios below 50 percent and avoid taking out new cards.

Credit cards can also affect your ability to qualify for the loan you want because the required payments are added to the payments associated with the mortgage in determining how much you can afford. The “total expense ratio” calculated by lenders and used in qualifying borrowers is the sum of the mortgage payment, property taxes, homeowners’ insurance premium, and other debt service, including credit cards, all divided by the borrower’s gross income. However, if you can keep your other debt service payments below 8 percent of your gross income, it will not limit the amount you can borrow.

You need some cash to buy a house, for down payment and settlement costs. Generally, the larger the down payment the lower the cost of the mortgage, but the relationship is notched, not smooth. If you go from nothing down to 3 percent down, the cost of the mortgage will drop; if you go from 3 percent to 4 percent, it won’t, but from 3 percent to 5 percent it will. While there are exceptions, the major notch points are 0 percent, 3 percent, 5 percent, 10 percent, 15 percent and 20 percent. For someone in your position, 3 percent is a reasonable target.

In sum, when your card utilization ratios are below 50 percent, your total debt service payments below 8 percent of your gross income, and your target down payment is in hand, you are ready!

What is a 15-Year Balloon?

“I have been offered an 80/20 loan on which the second mortgage (for 20 percent of price) is a 15/30 balloon. As I understand it, I have to pay off the balance of this loan after 15 years, which worries me. Should it?”

No, in the worst case you will have to refinance in 15 years.

Balloon loans all have terms of 30 years, meaning that the payment is calculated over that period, but the balance is due earlier. The most widely available balloons have been for five and seven years, and are viewed as alternatives to 5- and 7-year adjustable-rate mortgages (ARMs). The rates are a little lower on the balloons because there is no limit on the rate at which they are refinanced when the five or seven years is over. ARMs do have such a limit.

The 15-year balloon has become popular for a completely different purpose: they are used as the second mortgage in a piggyback arrangement.

Many borrowers putting less then 20 percent down take piggyback deals instead of buying mortgage insurance. A piggyback is a first mortgage for 80 percent of value and a second mortgage for 5 percent, 10 percent, 15 percent or 20 percent of value, depending on how much of a down payment the borrower makes. Sometimes the second mortgage is adjustable rate, but an increasingly common option is the 15-year balloon.

It should not be a source of anxiety. Most home buyers are not in the same house 15 years later; they have since moved and paid off both mortgages. Among those who are still there, a number have channeled extra payments to the second mortgage and paid it off within the 15-year period. (One of the advantages of a piggyback is that it allows borrowers to channel extra payments to the high-rate loan). Of those still in the house after 15 years who have a balance on the second, the great majority will have enough equity to refinance both loans into one on advantageous terms.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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