DTI Ratio: Should I Pay Off My Car Before Buying a House?

DTI Ratio: Should I Pay Off My Car Before Buying a House? 

Introduction

Deciding whether or not to pay off your car before applying for a mortgage can significantly impact the terms you get on your loan. As you think through this decision and weigh your options, understanding how mortgages work and how existing debts influence your mortgage application is crucial. This decision involves weighing the benefits of a lower debt-to-income ratio against the potential impact on your ability to save for a down payment or an emergency fund. In this guide, we’ll explore the pros and cons of paying off your car loan before getting a mortgage and how it affects your mortgage application. 

Understanding the Impact of Car Loans on Mortgage Applications

How Car Loans Affect Your Debt-to-Income Ratio

Your debt-to-income (DTI) ratio is one of the key factors that lenders consider when evaluating how much you qualify to borrow. This ratio measures the percentage of your gross monthly income that goes toward paying your debts, including your car loan. A high DTI ratio can signal financial stress, which lenders view as a higher risk, potentially leading to higher interest rates or even denial of your mortgage application.

Car loans contribute to your DTI ratio, so having an outstanding balance can affect your mortgage application. By paying off your car loan, you lower your overall debt, which can improve your DTI ratio and make you a more attractive applicant for a mortgage that will likely get you better loan terms and lower interest rates.

Pros of Paying Off Your Car Loan Before Applying for a Mortgage
1. Improving your debt-to-income ratio

One of the primary benefits of paying off your car loan before buying a home is the improvement in your DTI ratio. With one less debt to account for, your DTI ratio decreases, which can enhance your chances of a favorable mortgage. A lower DTI ratio demonstrates to lenders that you have a manageable level of debt relative to your income, making you a more reliable borrower.

2.  Enhancing your credit score

Paying off your car loan can also raise your credit score. A lower credit utilization rate and a history of timely payments will contribute to a higher credit score. Since your credit score plays a crucial role in determining your mortgage eligibility as well as interest rates and terms, improving it can lead to a better mortgage.

3. Increasing your mortgage affordability

With a reduced DTI ratio and an improved credit score, you may be able to qualify for a larger mortgage amount. This can increase your purchasing power and allow you to afford a more expensive home or secure a better rate, ultimately saving you money over the life of the loan. Additionally, paying off your car loan early will free up more cash each month. 

Cons of Paying Off Your Car Loan Before Getting a Mortgage

1. Financial strain from paying off a car loan

One potential downside of paying off your car loan before applying for a mortgage is the financial strain it might impose. Using a significant portion of your savings or diverting funds from other financial goals to pay off the car loan could impact your ability to cover a down payment or manage closing costs associated with the mortgage.

2. Opportunity cost

The funds used to pay off your car loan could potentially be invested elsewhere. If the interest rate on your car loan is lower than the potential return on investments or savings, it might make more sense to keep the car loan and invest the funds. Assessing the opportunity cost of paying off the car loan versus investing in other financial opportunities is an important consideration.

Consulting with a Mortgage Lender to Get Feedback

We always recommend that our members consult with a mortgage lender to understand how much they qualify for and what their financial strengths and weaknesses are. Consider asking the following questions to a lender:

• How will paying off my car loan affect my mortgage application and approval chances?
• What are the potential financial impacts of using funds to pay off the car loan versus investing them elsewhere?
• Can you help me evaluate alternative strategies to improve my mortgage application without paying off the car loan?

If you are saving for your first home and need help navigating the process and making decisions like this one, Foyer can help. Foyer was designed to help first time homebuyers navigate their path to homebuying more confidently.