While these ratios vary by loan program, down payment and other factors, the second is usually 8 percent more than the first. This has a quirky implication that does not make a lot of sense, but it is the rule. The implication is that the loan amount for which a borrower can qualify is not affected by the amount of a borrower's existing debt service payments until these payments reach 8 percent of gross income.

Hence, you can eliminate any impact of debt service on the amount you can borrow by paying down as much debt as needed to get to the 8 percent level. You can minimize the amount of cash needed for this purpose by paying the debts with the highest rates and shortest repayment periods. What is left can be used for your down payment.

Some borrowers with both cash and debts might prefer to use the cash to minimize the cost of the new loan, rather than to maximize the amount they can borrow. They should put 20 percent down to avoid the cost of mortgage insurance, and use the rest of the cash to pay off the debts with the highest rates.

"Am I correct that it doesn't pay to refinance if I have only had my house a year? And it doesn't pay to make extra payments to principal when I expect to sell in two years?"

Wrong on both counts!

The refinance decision, if made rationally, has nothing to do with how long you have had your house and mortgage. What matters is the interest rate on the old loan relative to the rate on the new loan; the balance on the old loan; the cost of the new loan; and how long you expect to hold the new mortgage. How long you have already held it doesn't matter.

Expectations about future tenure are important because a refinance trades off a lower interest rate, the benefit from which grows over time, against the upfront costs of the refinance. The period over which the benefits just equal the costs is the "break-even period." If you don't hold the new loan that long, the refinance is a loser. You can find the break-even period on any proposed refinance using the series three calculators on my Web site.

The decision to make extra payments to principal, in contrast, is affected neither by how long you have been in the house already nor how long you expect to hold it in the future. When you make extra payments to principal, you are reducing your debt and increasing your equity in the house. You will realize this benefit when you sell, regardless of when this happens.

For example, let's assume you pay an additional $100 in principal on May 1 and you sell the house on May 15. Then the amount you net at the sale will be higher than it would have been had you not made the extra payment. The difference will be $100 plus the interest on $100 for 15 days, which you would otherwise have had to pay.

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

Copyright 2003 Jack Guttentag