Paying Off Debt at Closing: How It Can Help You Qualify for a Mortgage

Paying off debt at closing is fairly routine for escrow companies. It can allow mortgage applications that would otherwise fail to fly through. And it can sometimes earn you a lower mortgage rate than you’d otherwise get.

That’s because committing to paying off debt at closing often allows your lender to adjust your debt-to-income ratio (DTI) as if you’d already paid off the relevant debt. And a high DTI can jeopardize your approval.

What Does Paying Off Debt at Closing Mean?

Once your new mortgage has been finally approved, you’re ready to move to closing. Closing can mean signing final documents. But it’s also used to describe the event a few days later when the lender issues the funds and the loan is officially active. This is also known as the funding day.

On the day of funding, you can choose to have the escrow agent or attorney pay some or all your existing debts on your behalf. This is most common during a home sale or cash-out refinance, but can also happen during purchase transaction.

On a home sale or refinance, the home’s equity is used to pay off debt. With a purchase transaction, needed funds are added to other closing costs, like the down payment and closing fees.

But why not pay the debts yourself?

Well, having the escrow company or lawyer make the payments directly to your creditors means you can’t use the cash for other things. And that allows your lender to treat your mortgage or refinance application as if the debts had already been paid.

Before closing, send your latest debt statements to the agent or attorney. That way, he or she will know how much to pay and to whom.

How Paying Off Debt at Closing Helps You Qualify

Your DTI can make or break your application. It speaks to whether you will have the monthly income to pay back the loan and keep up with other debt payments.

If you make $6,000 per month, for example, the lender is much more willing to lend to someone with only $2,000 is mandatory payments over someone with $4,000 in monthly obligations.

DTI is calculated by adding up all your monthly debt payments (minimum card payments and repayments on installment loans, such as student, auto, and personal loans) plus any monthly obligations including alimony and child support. That’s divided by your gross (before tax) monthly income and multiplied by 100.

DTI Example

For ease of arithmetic, let’s suppose your monthly debts total $4,200 and your monthly income is $10,000. On your calculator, $4,200 ÷ $10,000 = 0.42. Multiply the 0.42 by 100 and you get 42. Your DTI is 42%.

That’s absolutely fine for just about all mortgages, and your lender’s unlikely to worry about it.

But suppose your debt payments are bigger. Well, a DTI no higher than about 45-50% is often fine for a conventional loan, and FHA loans can sometimes be approved with a DTI of up to 56%, especially with strong credit and a low loan-to-value (LTV).

Paying off Installment Debt vs Revolving

Debt falls into two groups: installment and revolving. Installment loans include things like mortgages, auto loans, student loans, personal loans and the like. You borrow a lump sum and repay it in equal installments (sometimes adjusting to changes in interest rates, if it’s a variable-rate loan).

Paying off Revolving Debt at Closing

Revolving credit comprises mostly credit cards, but home equity lines of credit (HELOCs) also fit the definition. With revolving debt, you get a credit limit and can borrow, repay and re-borrow as often as you like.

It’s probably a good idea to pay off your card balances first when you close. That’s because:

• Cards tend to have higher interest rates than other debts, so you’ll save more.

• Your score should immediately improve when your credit utilization drops, making future borrowing less costly.

Do you have to close revolving accounts if paid off at closing?

Unless your lender insists, it’s generally a bad idea to close a credit account (revolving or installment) unnecessarily. Doing so affects another — though less important — component of your credit score: the average age of your accounts.

Conventional loans: You don’t have to close the account. No payment is counted against your DTI.

FHA and VA: You don’t have to close the account. However, these agencies will assume that you will continue to use the card and will add $10 a month to your DTI as a notional minimum payment.

If you’re worried you might run up your balances again, closing a card account is a good idea. Unless, that is, you’re confident that cutting up the card or locking it away will be sufficient for you to avoid temptation.

Paying Off Installment Debt at Closing

For conventional mortgages, installment loans that are due to be paid off within 10 months don’t count toward your DTI. You can also reduce your balance on an installment loan to nine payments, which eliminates them from your DTI as well.

However, the FHA specifies that this applies only if “the cumulative payments of all such debts are less than or equal to 5 percent of the Borrower’s gross monthly income.” So, prioritize paying down those that do affect your DTI.

Paying off Collections, Charge-Offs of Non-Mortgage Accounts, Judgments, and Liens

Under the heading “delinquent credit,” Fannie Mae specifies a whole list of debts that must be paid off at or before closing:

• Taxes — Any overdue taxes: state, federal, property and others.

• Judgments — Any court order requiring you to pay a debt.

• Charge-offs of non-mortgage accounts (see below for exceptions) — Debts that your creditor has written off but for which you’re still legally liable.

• Tax liens — “LIEN is a charge upon real or personal property for the satisfaction of some debt or duty ordinarily arising by operation of law,” says Merriam-Webster. A lien is registered with your county’s records office and stops you from disposing of the property before settlement.

• Mechanic's (aka materialmen’s) liens — A lien put against the home by a contractor due to unpaid work completed on the home.

• Liens that have the potential to affect Fannie Mae’s lien position or diminish the borrower’s equity — These might include a second mortgage, such as a home equity loan or HELOC.

Fannie says that delinquent federal income taxes may be counted as part of your DTI rather than be paid on closing, but only provided you’ve agreed to a repayment plan with the IRS. However, that does not apply if “there is any indication that a Notice of Federal Tax Lien has been recorded against the borrower in the county in which the subject property is located.” If such a lien exists, you must settle the full tax liability on or before closing.

The charge-off exceptions mentioned in the bullet points say, “non-medical collection accounts and charge-offs on non-mortgage accounts do not have to be paid off at or prior to closing if the balance of an individual account is less than $250 or the total balance of all accounts is $1,000 or less. Non-medical collection accounts and charge-offs on non-mortgage accounts that exceed these limits must be paid off at or prior to closing.”

Rules may be different for FHA, VA, and USDA loans. If you think you may be affected by these issues, talk with your loan officer.

Should You Pay Off Debts Before Applying?

The standard advice to borrowers is to pay down debt as much as you can, months before making an application for a big loan. First, focus on reducing card balances to 10% of their credit limits because that delivers the double whammy of lowering your DTI and boosting your credit score.

After that, reduce installment loans, starting with the one with the highest interest rate. Try to get as many as possible down to the level where there are 10 or fewer payments left to make.

Yes, that’s the standard advice. But, no matter how hard they try, many are unable to make much progress in a matter of months. If that’s the case, and you have enough equity, the “paying off debt at closing” strategy is a good alternative.

Paying Off Debt at Closing — The Bottom Line

Paying off debt at closing can help you qualify for a loan even if your current DTI is too high. You just have to commit to paying down at least enough debt to move your DTI into the approval zone.

Then, on closing, the escrow agent or attorney will deduct your debt payments from the settlement account and pay your creditors directly.

How much debt you can pay down in this way will depend on the amount of equity you have in your home. You need your home’s market value to exceed your mortgage balance by the sum you plan to repay, plus your new mortgage’s LTV requirement.

As you’ve discovered, some of the concepts and rules are quite complicated. So, your best way forward may be to consult with a friendly loan officer or a trusted financial advisor.