Taking steps to consolidate debt can make sense in a range of different situations, whether you need to secure a better interest rate or are tired of making several credit card and loan payments each month. But what happens when you need to consolidate debt around the same time you plan on purchasing a home? While debt consolidation has the potential to lower your
debt-to-income (DTI) ratio, which would positively affect your credit score (and therefore your chance of being approved for a mortgage), it may have the opposite effect depending on your new loan's term length and monthly payment.
Key Takeaways
- Debt consolidation loans typically come in the form of personal installment loans, but it's also possible to consolidate debt with a balance transfer credit card or a home equity loan.
- The main factor debt consolidation plays a role in when applying for a mortgage is your debt-to-income (DTI) ratio, which is determined by comparing your monthly bill payments to your gross monthly income.
- The maximum DTI you can have to get approved for a mortgage depends on the type of home loan you apply for.
How Debt Consolidation Can Impact Your Credit Score
Debt consolidation can impact your credit score in a few different ways, but the positives can outweigh the negatives. It all starts with the fact that applying for a new loan prompts a hard inquiry on your credit reports, which can temporarily ding your score. This is because new credit makes up 10% of your FICO scores, and every new account you open is taken into consideration.
From there, you get the chance to improve your credit by making on-time payments on your new debt consolidation loan. This factor is important because, at 35%, your payment history is the biggest determinant of your FICO score.
Beyond that, paying off your existing credit card bills with the new loan will lower your credit utilization ratio overnight. This can also help your score, as how much debt you owe in relation to your credit limits makes up another 30% of your FICO score.
Debt Consolidation and Mortgage Approval
The exact requirements to get approved for a mortgage depend on the type of home loan you hope to have. For a conventional mortgage, the basic requirements to get approved include:
- Down payment of at least 3% to 5%
- 620+ credit score
- DTI ratio of 50% or less
The last basic requirement, your DTI ratio, is the major factor that can be impacted by debt consolidation. This factor is calculated by taking the sum of your monthly debt payments and dividing them by your gross monthly income. So, if your monthly debt payments add up to $2,000 and your gross monthly income is $6,000, your DTI is 33%.
Because consolidating debt at lower interest rates than you have now can lower your monthly payments, this step has the potential to lower your DTI. However, debt consolidation could also increase your DTI if you opt for a debt consolidation loan with a shorter term and a higher monthly payment.
Ultimately, this is why you'll want to consolidate debt with the longest term and lowest monthly payment you can qualify for if you plan to purchase a home. Remember you can always pay more than the required monthly payment on a personal debt consolidation loan, although you should confirm there are no prepayment penalties before you do so.
Refinancing and Debt Consolidation
Similar rules apply if you are planning to refinance a home around the time you're working on debt consolidation. The maximum DTI you can have for a refinance loan depends on the type of mortgage you plan to refinance with. For refinance loans backed by Fannie Mae, for example, the maximum DTI is typically at 36% but can be increased to 45% for borrowers who meet certain requirements.
Once again, this means that securing a debt consolidation loan with the lowest required monthly payment can make it easier to qualify for a home refinance loan. That's because, generally speaking, having a lower amount of bills to pay each month will tell lenders that you have more available income to make mortgage payments.
Considerations Before Consolidating Debt for a Mortgage
There are special considerations to think over if you're hoping to consolidate debt around the same time you purchase a home. Keep the following factors in mind:
- Check your credit score: Checking your credit score to see where you stand can help you determine whether you can qualify for a debt consolidation loan with the best rates and terms available today.
- Get pre-qualified: Most companies that offer personal loans for debt consolidation let you "check your rate" and see available monthly payments and loan terms before you apply.
- Figure out your old vs. new monthly payment: Once you have an idea of what your monthly payment could be with a debt consolidation loan, you can compare that amount to what you're currently paying toward credit card bills and other debts.
- Determine your DTI: Add up all your monthly debt payments, figure out your monthly gross income, and run the numbers to figure out your DTI. See if your DTI falls within the range to get approved for a home loan after you consolidate.
Types of Debt Consolidation and Mortgage Implications
While one of the most common forms of debt consolidation is a personal installment loan, there are other types of loans that can work for this purpose. Consider how each type of debt consolidation loan might impact your ability to get approved for a mortgage.
Personal Loan
Personal installment loans come with fixed interest rates, fixed monthly payments, and a set repayment term that doesn't change. As we mentioned already, getting a lower monthly payment on a personal debt consolidation loan can lower your DTI and make it easier to qualify for a mortgage. However, the opposite is also true, and a debt consolidation loan with a higher monthly payment could make qualifying more difficult.
Balance Transfer
Balance transfer credit cards offer a 0% annual percentage rate (APR) on balance transfers (and sometimes purchases) for up to 21 months, although balance transfer fees apply. Transferring debt to another credit card that has zero interest should lower your credit utilization ratio right off the bat, as your new payment will be much lower due to the lack of interest. However, you need to keep your old credit card accounts open with a $0 balance to keep your credit utilization ratio as low as possible.
Home Equity Loan
If you currently own a home and have considerable equity, you can consider borrowing money for debt consolidation with a home equity loan that uses your property as collateral. Just remember that some lenders will only let you borrow up to 85% of your home's value across all home loans you have, including the primary mortgage and home equity loan products.
Best Practices for Debt Consolidation and Mortgage Management
Managing the payments on a mortgage, a debt consolidation loan, and any other bills you have to pay can be challenging, but there are steps you can take to make the process easier. The following tips can help you maintain your finances and improve your credit score over time.
- Start using a written monthly budget: Borrowers need to avoid the overspending that got them into debt in the first place, and a written monthly budget can help. In lieu of writing out all your expenses and bills each month with pen and paper, you can also use a number of different budgeting apps to track your spending and create a plan for the money you earn.
- Pay all your bills early or on time: Since your payment history is the most important factor that makes up your credit score, making all bill payments on time (or earlier, if feasible) is crucial. You can even consider setting up some of your bills for automatic payments if you're afraid you'll forget.
- Avoid new debt: Consolidating several debts into a new loan can leave you with credit cards that have a $0 balance. Keeping these accounts open can help keep your credit utilization ratio lower, but you may want to store your cards in a safe so you're not tempted into new spending.
How Does Debt Consolidation Affect Credit Scores?
While taking out a new loan can cause a hard inquiry on your credit report that temporarily dings your scores, debt consolidation can help your credit score thereafter. Not only can making on-time payments on a new loan improve your score, but paying off debt can lower your credit utilization ratio.
What Factors Should I Consider Before Consolidating Debt for a Mortgage?
You'll want to consider not only the financial savings you could get with a debt consolidation loan but also whether your required monthly payments will go up or down. This factor can impact your DTI, which can affect your ability to qualify for a mortgage.
How Do Lenders Evaluate Mortgage Applications With Debt Consolidation?
Lenders look at several factors when considering a mortgage application, including your regular income, your credit score, your down payment amount, and your debt-to-income (DTI) ratio. As long as you meet the minimum mortgage eligibility requirements after you consolidate debt, the fact you have a debt consolidation loan won't make much of a difference.
What Are the Best Practices for Managing Debt Consolidation and Mortgages Simultaneously?
Start using a written monthly budget that plans out your spending in a thoughtful, comprehensive way, then track your actual purchases and bill payments throughout the month to make sure you stay on track. Pay all your bills on time each month, and do your best to avoid racking up new debts.
The Bottom Line
Debt consolidation can lead to significant financial benefits, especially for borrowers who have a lot of high-interest debts to pay down. This is true for people planning to purchase a home just like anyone else, although potential homebuyers will want to make sure they're consolidating debt in a way that doesn't impact the home-purchasing process. For the most part, this means choosing a debt consolidation loan that won't increase their DTI ratio so much that it hurts their ability to get a mortgage.
