August 13, 2024
by
McKenzie Hagan
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.
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Your debt-to-income (DTI) ratio is a simple calculation lenders use to determine how much of your monthly income goes toward paying debts. To find your DTI, add up all your recurring monthly obligations—such as credit cards, student loans, personal loans, and car payments—and divide that number by your gross monthly income.
For example, if you earn $6,000 per month before taxes and spend $2,000 on debt payments, your DTI ratio would be about 33%.
Lenders rely on this figure because it gives them a snapshot of your financial health. A lower DTI ratio suggests you have enough income left over each month to comfortably manage a mortgage, while a higher DTI ratio signals greater financial strain and higher risk for the lender. Most mortgage programs prefer a DTI below 36%–43%, though exact limits vary by loan type. If you’re still exploring mortgage options, check out How to Choose a Mortgage Lender That’s Right for You for guidance on finding the best fit.
Understanding your DTI is essential before applying for a mortgage. It not only affects whether you qualify but also impacts your loan terms, interest rates, and the amount you’re approved to borrow.
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.
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.
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. For a deeper look at this connection, see How Credit Score Impacts Your Home Buying Process.
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.
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.
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.
Paying off your car loan may leave you with less cash on hand for unexpected expenses. Lenders like to see that you have reserves for emergencies, moving costs, or repairs. If you drain savings to pay off a car, it could signal to underwriters that you’re financially stretched, even with a lower DTI.
In some cases, yes. Large lump-sum payments can reduce your liquid savings, which underwriters check to ensure you have enough reserves. If your bank statements show a sudden drop in cash, lenders may question whether you’re financially prepared for ongoing mortgage obligations.
Making extra payments can lower your balance and improve your DTI gradually, while still keeping more cash in your savings account. This strategy may strike a balance between reducing debt and preserving funds for a down payment and closing costs.
Not necessarily. While eliminating the loan may improve your DTI and credit score, mortgage rates are also influenced by market conditions, your income, down payment amount, and overall credit profile. Paying off the car loan can help, but it doesn’t guarantee a lower rate.
How long after paying off my car loan should I wait before applying for a mortgage?
Your credit report typically updates within 30–60 days after paying off a loan. Waiting at least one full billing cycle ensures lenders see the change in your DTI ratio and credit score before reviewing your application.
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:
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.
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