Many people think that it is beneficial to pay off a car loan before applying for a mortgage. In reality, this could be a bad idea and actually cause you to lose your mortgage approval. The logic behind this theory might seem a bit strange, as it seems to be common sense to pay off a loan and have fewer outstanding debts when you apply for a mortgage, but that auto loan does more for your credit than you may realize.
The Need for Long-Term Credit
When you apply for a mortgage, lenders are looking for long-term credit on your credit report. They want to see that you have the ability to pay a loan over the span of many years. New credit raises red flags to lenders, making you seem like a risky borrower. If you have an auto loan that has been in existence for several years and has been paid on time, it will make you look more favorable when you apply for a mortgage.
The Case for a Lower DTI
In some cases, getting rid of a large car payment can lower the debt-to-income ratio enough to make it possible to get approved for a mortgage. If you have a borderline DTI, or worse yet, one that is too high, you will likely be better off paying your car loan off rather than holding onto it. If your debt-to-income ratio is already in line, then you will have to make the decision between keeping your car loan or paying it off before applying for a mortgage. If your credit needs some help and your car payments are always made on time, then you might be better off keeping the loan.
Payment History is a Big Factor
The payment history on your car loan is very important in the approval process. Even one late payment on your auto loan can bring your credit score down significantly. If this is the case, you might be better off paying the car loan off and waiting a few months to apply for a mortgage. If, on the other hand, you have a perfect payment history on your car loan, then it is worth keeping it on your credit report, as this will allow you to have a higher credit score.
The Money Needs to be Sourced
If you are purchasing a house, you might think that the money that you have left after selling your car and paying off the car loan could be used for a down payment. While the notion is nice, most lenders will not allow you to use this money. The money needs to be seasoned, which means that it needs to be in your bank account for at least 2 months. It will also need to be sourced. If the buyer provides you with a cashier’s check to pay for the car, you will have no problem sourcing the income. On the other hand, if he pays you with cash, it will be very difficult to prove to the lender where the large deposit came from, making it difficult to use the money for a down payment or even reserves.
The answer to whether or not you should pay off a car loan before applying for a mortgage depends on the situation. In most cases, it does not make sense to pay it off – you should wait until after you close on your mortgage. On the other hand, if you are overextended on your credit or your debt-to-income ratio is too high; it might be worth the hit that your credit will take by paying the loan off just to make you more capable of affording the new mortgage loan. As always, talk to your lender before making any financial decisions to determine how it would affect your specific situation.
Justin McHood is America's Mortgage Commentator and has been providing expert mortgage analysis for over 10 years.
