Does a Debt Consolidation Loan Affect Getting a Mortgage?

Getting a mortgage to buy a home is an exciting yet stressful process. As you gather documents and fill out applications, a question may arise – how does your debt situation impact your mortgage eligibility? Specifically, if you took out a debt consolidation loan to lower your monthly payments, could that hurt or help your chances of getting approved for a home loan?

This is an important issue to understand before seeking mortgage pre-approval. The short answer is debt consolidation can influence getting a mortgage positively or negatively depending on your specific circumstances.

How Consolidation Loans Can Hurt Mortgage Chances

In certain situations, a debt consolidation loan could potentially have some drawbacks when it comes to qualifying for a mortgage:

• Hard credit inquiries When you apply for a consolidation loan, the lender will do a hard inquiry into your credit, which causes a small, temporary drop in your credit score. Even a 5-10 point dip could impact the mortgage rates you’re offered

• Higher debt load: Some consolidation loans charge origination fees, which increase the total amount you owe. Mortgage lenders look at your overall debt, so a larger consolidation loan could be a concern.

• Increased credit utilization: If you consolidate debt onto a credit card, your utilization ratio may rise, negatively affecting your score.

• Longer payoff time: Whereas mortgages are 15-30 years, consolidation loans are usually 1-7 years. If your total monthly debt payments don’t drop much, paying off the consolidation loan could take longer than your original debts would have, delaying your mortgage application.

How Consolidation Helps Mortgage Eligibility

The key is timing If done well in advance, debt consolidation can actually improve your mortgage chances

• Lower interest rate Combining debts into one loan or card with a lower APR makes repayment faster and cheaper, This frees up cash flow for mortgage payments

• Single payment: One lower monthly payment is easier to manage than multiple credit card, auto, and student loan bills. This also improves cash flow for mortgage payments.

• Lower utilization: As the consolidation loan balance drops, your credit utilization decreases, boosting your credit score.

• Payment history: Making on-time payments on the consolidation loan for a year or more builds positive credit.

• Lower debt load: As the consolidation loan balance declines over time, your total debt decreases, another factor mortgage lenders consider.

##Ideal Timing for Consolidation Before Mortgage

The takeaway is consolidation can assist mortgage eligibility if done at least 6 months to 1 year before applying. This gives time for the benefits to help your credit score and financial situation. Avoid consolidating debts right as you begin the mortgage process, as the short-term score impacts could lead to higher rates.

Speak with a loan officer to discuss your personal situation. But in most cases, follow this ideal timeline:

• Consolidate at least 12 months before mortgage application
• Pay down a good portion of the consolidation loan’s balance
• Continue making on-time payments
• Check your credit 6+ months after consolidating to ensure your score is rebounding
• Apply for mortgage pre-approval once your score has improved and the consolidation balance is well below original debts

What Mortgage Lenders Look For

Why is your credit score and debt-to-income ratio so important to mortgage lenders? What criteria do they use to determine if you qualify for a home loan?

Credit Score

According to myFICO, you need a minimum credit score of 620 for FHA loans and 680 for conventional mortgages before lenders will consider your application. The higher your score, the better the rates and terms you’ll be offered.

Here are the credit score requirements mortgage lenders typically have:

• 760+ = Excellent credit – best rates
• 700-759 = Good credit – good rates
• 680-699 = Fair credit – decent rates
• 620-679 = Poor credit – higher rates/fees or denial
• Below 620 = Very poor – likely denial

Debt-to-Income Ratio

Lenders look at your total monthly debt payments divided by your pre-tax monthly income. This includes the new mortgage payment you’re requesting plus existing debts like credit cards, auto loans, student loans, and the consolidation loan.

Here are typical debt-to-income (DTI) requirements:

• 36% max DTI to get the best mortgage rates
• Up to 50% allowed with good credit for conventional loans
• Up to 55% allowed for FHA loans

The lower your DTI, the better mortgage terms and rates you can get approved for, since it shows you can afford the new monthly payment.

Alternatives to Debt Consolidation

Besides taking out a consolidation loan or balance transfer card, here are a couple other ways you could try paying off debts before getting a mortgage:

• Debt snowball: Pay minimums on all debts except the smallest, which you aggressively pay off first. Repeat this method as you pay off each small debt until everything is gone.
• Cash-out mortgage refinance: If you already have sufficient home equity, you could cash-out some equity to pay other debts, rolling it into a new mortgage. Just be sure your DTI stays low.
• Use windfall: If you receive a tax refund, inheritance, bonus, or other large amount of cash, put it toward eliminating debts.
• Budgeting: Free up money to pay more than minimums by reducing expenses. Make coffee instead of buying it, downgrade phone and cable plans, etc.

The idea is to get monthly debt payments and total balances as low as possible before applying for a mortgage, so your DTI and credit score will be optimal.

Weighing the Pros and Cons

Only you can decide if getting a debt consolidation loan is the right move before buying a home. Carefully consider these key pros and cons:

Pros

• Lower interest rate saves money
• Single payment is easier to manage
• Builds positive payment history
• Lowers credit utilization
• Results in lower balances
• Could improve chances of mortgage approval

Cons

• Loan origination fees increase total debt temporarily
• Hard credit check causes small score drop
• Monthly payments might not drop much or could increase
• Loan payoff timeframe could be longer than original debts
• Poor timing could hurt mortgage approval odds

If you have a solid credit score and low debt already, consolidation may not make sense. But for those with fair credit and high balances, it can be a smart step on the path to mortgage qualification.

Consulting the Experts

As you weigh consolidation versus other debt payoff methods before buying a home, don’t go it alone. Turn to the professional for guidance.

• Mortgage lender: Provide details on your current debts and credit and ask how consolidating could impact your mortgage application.

• Credit counselor: They can pull your credit report and offer tips to improve your score. Ask if consolidation is recommended in your situation.

• Financial advisor: Talk through your overall budget, expenses, and savings to come up with a personalized debt payoff strategy.

The experts can look at the full picture and run the numbers to tell you if consolidation is likely to help or hurt your mortgage chances. Don’t consolidate debts blindly – make an informed decision.

The Final Word

Preparing your finances for a mortgage by paying off debts takes planning and discipline. The right debt consolidation approach could give your credit score and DTI the boost needed to qualify for a great home loan.

But poor timing could do more harm than good. Make sure to consolidate at least 6 months to a year before you apply for mortgage pre-approval so the benefits have time to build before the lending process begins.

If you do decide to consolidate existing debts on the path to homeownership, remain diligent about paying off your consolidation loan quickly and maintaining on-time payments. This financial legwork in the months or years leading up to a mortgage application could reward you with better terms and lower rates, potentially saving tens of thousands over the loan’s lifetime.