Are you ready to buy a home but still tied to a personal loan? For myriad reasons, you may want to eliminate that loan before getting a mortgage—and in many cases, that’s a good instinct. The best mortgage lenders will often appreciate fewer monthly bills.
Still, the answer isn’t quite that simple. Whether you should first pay off your personal loan depends on your financial situation. Here’s what you need to know.
Why should I pay off my personal loan before getting a mortgage?
There are many reasons to pay off a personal loan before you take out a mortgage—from lowering your monthly payments to reassuring the financial institution that you can afford a new loan.
Lower your debt-to-income ratio
Your debt-to-income ratio (DTI) is one of the most important details when it comes to a mortgage approval. Lenders want to know that you have the ability to pay your mortgage each month, and your DTI helps to give them an idea of your current financial commitments. If 60% of your money currently goes toward credit card bills, an auto loan, and a personal loan, it may be more difficult to get a mortgage approved until you eliminate some of those monthly obligations.
In this case, paying off a personal loan before getting a mortgage could help tremendously.
Potentially increase your borrowing power
On a related note, fewer debts can result in qualifying for a larger mortgage. If you’ve got more disposable income, you can handle larger monthly payments. Depending on the size of the loan you need—and the size of your monthly personal loan payments—paying off your loan before requesting a mortgage could dramatically affect your borrowing power.
Fewer monthly payments
Lowering your debt-to-income ratio isn’t just beneficial for the lender; it’s great for you, as well. Paying off a personal loan will result in less financial strain for you each month, as more of your monthly budget is freed up for a mortgage payment. The fewer bills you’ve got, the better.
Downsides to paying off a personal loan before getting a mortgage
Paying off debt is always a good thing. But in some scenarios, it may be wise not to pay off a personal loan before opening a mortgage.
Your credit score may get dinged
You may be surprised to learn that paying off a personal loan has negative implications for your credit score. After you make the last payment on your personal loan, the account is closed. This means:
- Your average age of accounts may decrease (a factor that makes up 15% of your credit score)
- Your credit mix may be adversely affected (a factor that makes up 10% of your credit score)
If you’ve got very little left on your personal loan and it’s not affecting your DTI in a meaningful way, it may be best not to pay off your personal loan until you’ve taken out a mortgage.
You may miss out on great rates
You may not be able to pay off your personal loan for years to come. There’s nothing wrong with committing to eliminate as much debt as possible before acquiring a new loan, but it’s worth considering the current housing market. If you find rates to be favorable, the same rates may not be there by the time you pay off your loan in the coming years.
If you can comfortably manage it, you may save the most money in the long run by locking in rates before your loan has been paid off.
You’ll sacrifice an emergency fund
Those looking for a mortgage in the near future may be tempted to throw money toward paying off a personal loan that they otherwise would be reluctant to touch. Be smart when dipping into an emergency fund to more quickly pay off a personal loan. The emergency fund is there for a reason.
Pros and cons of paying off a personal loan before getting a mortgage
Pros
- Decrease your debt-to-income ratio
- Lower your monthly payment obligations
- Possibly qualify for a larger mortgage
Cons
- Length of credit history may decrease, slightly lowering your credit score
- Credit mix may be negatively affected, slightly lowering your credit score
- One less account means fewer opportunities to exhibit positive payment history
Other ways to improve your mortgage approval odds
There are other ways to improve your chances at being approved for a mortgage other than paying off your personal loan debt. Here are a few powerful things you can do:
- Continue to make on-time payments: The weightiest factor of your credit score is your payment history. Missing payments is the fastest way to sabotage your credit health and scare away potential lenders.
- Lower your credit utilization: If you’re carrying high balances on revolving credit lines (such as credit cards), you can dramatically improve your credit score by paying down those debts. Experts recommend keeping your amounts owed to 30% or less of your total available credit to avoid a negative effect on your credit score.
- Increase your down payment: With a meaningful down payment, you can exhibit financial responsibility to lenders.
- Search for prequalification: You can see which mortgages you’ll likely be approved for by disclosing some personal information, such as the home you want and the loan you need. Being preapproved is like a soft commitment from a financial institution that outlines how much you can borrow, your proposed APR, etc.
The takeaway
In many cases, paying off a personal loan before applying for a mortgage is beneficial. Your DTI will decrease and your monthly bills will be lower.
But paying off an installment loan can slightly lower your credit score. You also shouldn’t sacrifice an emergency fund for the sake of paying off a loan.
Frequently asked questions
What debt-to-income ratio do I need to qualify for a mortgage?
The exact debt-to-income ratio (DTI) required for a mortgage varies, but a good rule of thumb is 43%. Some lenders may not approve you for a mortgage if your DTI exceeds this.
Should I pay off debt or save for a down payment?
Paying off debt and saving for a down payment are both critical when it comes to money savings and your odds of being approved for a favorable mortgage. However, if your DTI is too high, your chances of being approved for a mortgage plummet. Rather than saving up for a large down payment, paying off debt may take priority. After all, some mortgage types require a down payment between 0% and 3.5%.
Will paying off my personal loan hurt my credit score?
Paying off your personal loan can drop your credit score slightly. This is because when you pay off an installment loan, your account is automatically closed, which can affect your average age of accounts and your credit mix.
What types of debt should I prioritize paying off before buying a home?
You should prioritize paying off debt on revolving credit lines like credit cards, as these count against your credit utilization—a factor that makes up 30% of your overall credit score. You should also prioritize paying off loans that demand a large portion of your income to keep your budget from straining when opening a mortgage and taking on a new monthly payment.