Paying off personal loans and borrowing for your home are great financial goals. But which should you prioritize?
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For many people, their mortgage loan is the biggest debt they take on. Because a mortgage loan is such a big loan -- and is paid off over such a long period of time -- it’s important you qualify for the very best mortgage rates you can get.
To get a lower interest rate on your mortgage, you’ll want to do everything you can to be the ideal borrower. This means having a great credit score and otherwise excelling in the metrics lenders look at when they decide whether to give you financing and at what rate.
When you’re looking for ways to become a more qualified borrower, you may find yourself wondering if it makes sense to pay off an outstanding personal loan before you apply for a mortgage. Unfortunately, there’s no one right answer to this question -- but here are a few things to consider to help you decide.
Reasons to pay off a personal loan before applying for a mortgage
There are a few big reasons why it makes a lot of sense to pay off a personal loan prior to applying for a mortgage:
Paying off the personal loan can improve your debt-to-income ratio.
Your debt-to-income ratio is the amount of debt you have, relative to income. If your total debt payments, including your mortgage and other loan costs, add up to $1,200 monthly and you have a $4,000 monthly income, your debt-to-income (DTI) ratio is $1,200/$4,000 or 30%.
Most mortgage lenders won’t give you a loan if your debt-to-income ratio exceeds 43% at the most. Many lenders require an even lower debt-to-income ratio to qualify -- but even if it’s not required, a lower DTI is looked upon more favorably and can help you qualify for a mortgage loan at a better rate.
You’ll have one less debt payment after you become a homeowner.
Becoming a homeowner comes with a whole host of new expenses, from buying furniture to paying for someone to mow your lawn (or for the equipment and gas to mow it yourself). You’ll also have property taxes, utility bills, home repair costs, and HOA fees -- depending on where you live.
When you have all these expenses, you don’t want to owe a lot of money to creditors on top of paying your regular monthly bills. If you pay off your personal loan, you’ll free up cash you can put towards an emergency or home repair fund or can use to cover other costs of homeownership.
Reasons not to pay off a personal loan before applying for a mortgage
Of course, there are also some reasons why you might not want to pay off a personal loan prior to the time you apply for a mortgage. It’s important to carefully consider these issues, as paying off a personal loan could potentially make it harder to get a good deal on a home in some circumstances.
Paying off a personal loan won’t necessarily improve your credit.
Paying off credit card debt reduces your credit utilization ratio, or the amount of credit used relative to credit available. This improves your credit score.
But repaying personal loans early doesn’t necessarily cause your score to improve. If you’re paying your personal loan on time each month, having a mix of different credit on your credit report can actually help boost your score.
You could deplete your down payment fund or cash reserves.
It’s a good idea to put down at least 20% on a home. While many lenders allow you to put down less, you will likely have to pay Private Mortgage Insurance (PMI) if your down payment is smaller than 20% of the home’s value. PMI could cost around .5% to 1% of your loan’s value annually, so it can be quite expensive.
A higher down payment can also help you get a mortgage at a better rate and can reduce your chances of ending up owing more than the home is worth, which causes a whole host of problems including making it very hard to sell your house.
If you use a bunch of money to pay off your personal loan early, you’ll deplete the money you have for a down payment and may end up having to put down less. This makes it harder to qualify for a mortgage and often more expensive.
Some mortgage lenders also require you to meet certain requirements for cash reserves -- such as having a few months worth of mortgage payments in the bank. Spending your cash on a personal loan could make it harder to fulfill this requirement.
Plus, of course, if you’ve spent your cash on the personal loan, you have less money for an emergency fund or other costs you may incur as a homeowner.
Personal loans usually have a relatively low interest rate.
The rate on a personal loan is usually lower than other kinds of consumer debt, such as credit card debt -- although mortgage interest rates are typically lower than personal loan rates.
It makes no sense to pay off a personal loan if you have other debt at higher rates, such as credit card debt. And, it makes no sense to pay off the personal loan if doing so could force you to borrow more on your credit cards after you close on your home to cover moving costs, home repairs or other expenses.
You could delay your home purchase.
If you decide to wait to pay off a personal loan, you could delay the purchase of your home as you work to find the money to repay your loan. As you wait, mortgage interest rates could potentially rise, making your mortgage more expensive. You also get stuck paying rent for longer and delay the time when you can begin building equity in your home.
What’s the right choice for you?
Ultimately, you’ll need to consider the specifics of your own situation. If paying off your personal loan could make it impossible for you to make a 20% down payment, make you susceptible to getting into more debt later, or delay your home purchase, it’s often not worth it.
But, if your personal loan payments are making your debt-to-income ratio too high or there’s a risk you can’t afford both your personal loans and the costs of being a homeowner, you should wait and pay off the loan first before buying a home.
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