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Personal loans can have an effect on your mortgage application, and it can be good or bad, depending on the situation.
If you're planning to buy a home in the next few years, applying for a personal loan could potentially reduce how much you can borrow for a home, and could also affect your credit, depending on how you manage the debt. Here's what you need to know before you apply.
How Do Personal Loans Work?
Personal loans are a form of installment credit that offer borrowers access to the full loan amount upfront in exchange for regular installment payments over a set repayment term.
One key characteristic of personal loans that sets them apart from many other loan types is that most of them are unsecured, which means there's no collateral involved. Also, with few exceptions, borrowers can use personal loan funds for just about anything they want.
In return, personal loans typically charge higher interest rates than secured loans, such as mortgage and auto loans, so they're not always the best option if you're planning a large purchase.
Will a Personal Loan Affect My Mortgage Application?
Yes, getting a personal loan before buying a house can impact your mortgage application. Any debt you have listed on your credit reports can affect your ability to get a mortgage loan. There are two primary things lenders will look for with personal loans: how you've managed the debt and how it affects your debt-to-income ratio.
Your Payment History
Making on-time monthly payments is crucial with any type of debt, especially if you're planning to apply for a mortgage loan. A mortgage is a long-term commitment for both you and the financial institution, so if you've missed any payments on your personal loan, you may qualify at a higher rate or not at all.
If you've managed to pay all your bills on time, however, this may have improved your credit score over time, as well as your chances to get approved for a mortgage.
Your Debt-to-Income Ratio
When determining how much you qualify to borrow, mortgage lenders will look at your back-end debt-to-income ratio (DTI), which is your total monthly debt payments divided by your monthly gross income.
For reference, your front-end DTI is how much of your gross income goes toward housing costs only. If your back-end DTI ratio is very low, the personal loan payment may not make much of a difference. However, most lenders prefer a back-end DTI below 36%, and if yours is higher than that with the personal loan payment, you may not qualify for as much as you want or need.
What if I'm Currently Paying Off a Personal Loan?
If you've already taken out a personal loan and are considering applying for a mortgage, the best thing you can do is to continue making your payments on time.
If you're close to the end of your repayment term and can afford to pay off the remainder before applying, eliminating the debt could improve your chances of getting the loan amount you're looking for. If you can't, however, just focus on maintaining a positive payment history.
How to Increase Your Chances of Getting a Mortgage
In most cases, having a personal loan won't make or break your chances of getting approved for a mortgage. If you're worried, however, here are three key things you can do get your credit ready for a mortgage:
- Work on getting your credit ready for a mortgage by checking your credit reports and scores to see if there's anything you need to address before you apply. If you find any issues, waiting until you can improve your credit could save you thousands, if not tens of thousands, over the life of a mortgage loan.
- Avoid taking on new credit leading up to your mortgage application. The last thing you want to do is to increase your DTI even further. If you have time, consider working on paying down some loans and credit cards to potentially decrease your DTI.
- Consider taking some time to increase your down payment amount. The more money you put down, the less of a risk you pose to mortgage lenders, potentially increasing your approval odds.
Avoid Jumping Into a Mortgage Too Soon
Homeownership is an exciting prospect, and it can be easy to get caught up in the emotional side of taking that big step in life. But if you commit to a mortgage loan before you're financially ready, homeownership could become more of a burden than a blessing.
Make it a priority to check your credit score and work on improving it long before you apply. Also, create a budget to determine how much you can actually afford to pay each month, keeping in mind that what the lender offers you may actually be out of your price range. As you do so, don't forget about other housing costs, such as private mortgage insurance, property taxes, homeowners insurance, repairs, maintenance and more.
As you approach getting a mortgage loan this way, you'll have a much better chance of getting approved for one and being able to make the payments each month.