Buying a home is a significant financial commitment, both for you and the mortgage lender. As a result, the underwriting criteria can be strict. There are many factors that lenders consider, but your credit score and debt-to-income ratio are among the most important.
Paying off a car loan can help you improve your readiness for a mortgage, but it may not necessarily be the right decision. Here’s what to consider before you proceed.
Should I Pay Off My Car Before Buying a House?
Your debt-to-income ratio, or DTI for short, is a crucial factor in determining your eligibility for a mortgage, as well as how much you can borrow. This ratio measures how much of your gross monthly income goes toward debt obligations in the form of a percentage.
For example, if you have $1,200 in monthly debt payments and a $5,000 monthly salary, your DTI is 24%. Mortgage lenders typically prefer that you have a DTI of less than 36%, though some lenders can go to 43% or higher, according to the Consumer Financial Protection Bureau.
“A car loan is treated like any other installment debt in the DTI calculation,” says Mike Tassone, co-founder and chief operating officer of mortgage marketplace Own Up.
[Read: Best Mortgage Lenders]
If your DTI is too high, paying off one of your loans can potentially lower it enough to improve your chances of getting approved for the home you want. But there are some things to consider first:
— Your budget. Your DTI is an important metric, but it doesn’t necessarily tell you the full story about your financial situation. If you believe that taking on a new mortgage payment could stretch your budget too thin, paying off your car loan or another debt — or buying a less expensive home — might be the right move.
— The loan payment. Look up your auto loan payment and compare it with all of your other debt payments. If you have a larger payment on another loan or credit card, consider paying off that account instead.
— Your cash reserves. Any money that you put toward your car loan is money that you can’t use for a down payment or emergency expenses. And depending on the type of loan you’re trying to get, the lender may have a cash reserve requirement. Remember, too, that you can’t get that money back once you’ve paid it. “If you need to put more money down than you were anticipating, you could put yourself in a less-than-ideal position if you had just fronted the additional money for your vehicle,” says Austin Horton, product owner at Volo Loans, which offers financing to U.S. citizens buying property abroad.
— Your credit score. Paying off a loan can sometimes result in a temporary dip in your credit score. If your score is very high, it might not matter. But if it’s low enough that every point counts, it might be worth waiting.
One alternative to paying off the car loan is to pay down the balance just enough for the lender to ignore it. “One nuance with installment debt is that most lenders will not include installment debt with 10 or fewer monthly payments remaining,” says Tassone.
If you’re uncertain about whether you should pay off your car loan to reduce your DTI or relieve some pressure on your budget, consider consulting a mortgage professional who can explain how paying off the loan could impact your situation and creditworthiness.
What About Buying a Car Before Buying a House?
Another decision you may be facing is whether to buy a car shortly before buying a home. Your current vehicle may be on its last legs, you may be getting out of a lease or you may simply want something different.
If you’re thinking about applying for an auto loan to finance the purchase, mortgage experts generally recommend that you avoid applying for new credit in the months leading up to a mortgage application. This is especially true if the new loan increases your DTI compared with your current auto loan.
Even if you’re planning to buy the car outright, that’s again money that you wouldn’t be able to put down on your new home. Depending on your cash situation, it could potentially impact your approval or make it difficult to cover emergency expenses after you get into your new home.
[READ: Best Auto Loan Rates and Lenders.]
While some financial experts may say don’t buy a car before buying a house, period, here are some things to consider:
— Timing. If you’re not planning on buying a home for another 12 months or more, the credit inquiry and new loan account might not have much of an impact on your mortgage approval. If you’ve already started the mortgage process, Tassone says, “we recommend waiting on opening any nonessential debt to make sure it doesn’t jeopardize your ability to qualify for financing.”
— Your DTI. If the new car loan doesn’t affect your DTI much, you may be in the clear.
— Cash reserves. Buying a car in cash may not have much of an impact — if you still have money left over for a solid down payment and emergency reserves. But holding onto your cash for now can still be a good move. “Having more reserves when purchasing a home can help you get approval when you might not get one under different circumstances,” says Horton.
As with the decision of whether to pay off a car, consider talking to a mortgage professional to get an idea of how buying a new one can affect you.
[Read: Best Mortgage Refinance Lenders.]
Should I Refinance My Car Before Buying a House?
Refinancing an existing car loan can affect your mortgage approval for better or for worse, depending on the situation.
The hard credit inquiry and new loan account may not have much of an impact, but if you can qualify for a lower monthly payment, either through securing a lower interest rate or extending your repayment term, it could help improve your DTI and make it easier for you to buy a home.
Additionally, if you owe less than the value of your vehicle, some auto lenders allow you to do a cash-out refinance of your car loan and get some of that equity in cash. You can use that money however you wish, including for a down payment on your new home.
That said, a cash-out refinance of your auto loan will increase your loan amount by the amount of the cash you’re receiving and could also result in a higher monthly payment, which impacts your DTI.
So, again, it’s a good idea to speak with a mortgage broker or loan officer to understand how refinancing your car loan can potentially help or hurt your chances of getting into the home you want.
[Calculate: Use Our Free Mortgage Calculator to Estimate Your Monthly Payments.]
Make Sure You’re Credit-Ready for a Mortgage
While you may be thinking about what to do with your auto loan situation, keep in mind that mortgage lenders look at a lot of different factors during the underwriting process. Here are some steps you can take to improve your credit leading up to your mortgage application:
— Check your credit score. Conventional lenders typically look for a score of 620 or above, but the higher it is, the better your chances of getting approved with a favorable interest rate. You may be able to check your FICO Score for free through your bank or credit card company or through Experian, one of the three major credit bureaus.
— Review your credit reports. Visit AnnualCreditReport.com and get a copy of all three of your credit reports. Read through your reports to make sure you recognize all of the accounts. If you don’t recognize one or you find inaccurate information, you may be able to dispute it and have it removed from your reports.
— Pay off smaller debts. If you can afford to pay off a loan or credit card without it impacting your down payment and emergency reserves, do that to decrease your DTI.
— Avoid opening new credit accounts. Unless OK’d by your mortgage broker or loan officer, try to avoid opening new credit accounts, including loans and credit cards.
If you can afford it, take more time to prepare. While it can be tempting to get into a home as quickly as possible, improving your credit could potentially help you save thousands or even tens of thousands of dollars on your mortgage.
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Should You Pay Off Your Car Before Buying a House? originally appeared on usnews.com
Update 04/24/24: This story was previously published at an earlier date and has been updated with new information.
