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Consolidate Debt Personal Loan Before Apply Mortgage?

Should you take out a personal loan to consolidate debt before you apply for a mortgage?

Harry Jensen, Trusted Mortgage Expert with 45+ Years of Experience
, Trusted Mortgage Expert with 45+ Years of Experience

Taking out a personal loan to consolidate debt may improve your ability to qualify for a mortgage but there are several points to consider. As we outline below, the answer to your specific question depends on how the loan impacts your credit score and monthly debt payments.

In some cases your credit score dips temporarily when you apply for a personal loan. In an ideal scenario you wait several months after you apply for the loan before you apply for the mortgage. As long as you make your personal loan payments on-time, your score should rebound and potentially improve over time.  

Additionally, paying down or paying off debt such as credit cards may improve your credit score in the medium-to-long run, which is beneficial when you apply for a mortgage. You may want to use a credit score simulator to understand how your score may change if you consolidate all or a portion of your debt.

Please note the interest rate on the personal loan should be less than the average interest rate on the debt you are consolidating. For example, if you have three credit cards that charge interest rates of 12%, 14% and 16%, respectively, the average interest rate on your credit card debt is 14%.

In this scenario, the interest rate on the personal loan should be less than 14% and hopefully significantly lower. Consolidating debt with a personal loan that has a lower interest rate enables you to reduce your total interest expense, which saves you money.  

Another point to keep in mind if you intend to consolidate credit card debt is that you should pay off the account balances completely, if possible. Incurring the additional debt of a personal loan and keeping balances -- and monthly payments -- for multiple credit cards does not make much financial sense and may actually hurt your ability to get approved for a mortgage.  The idea is to reduce the number of loan payments you make, not increase it. 

Additionally, if you currently have more than two credit card accounts open you may want to consider closing an account when you pay off the loan balance.  Having three or more open credit card accounts, plus a personal loan, may have a negative impact on your credit score and your mortgage application.

If you have two or fewer credit card accounts, instead of closing the accounts after you pay them off, we recommend that you keep them open with a zero balance. Having two credit card accounts open and showing a zero balance can have a positive impact on your credit score.

On the other hand, having no credit card accounts may actually have a negative effect on your credit score because your borrowing capacity is limited.  We should also emphasize that just because you have an open credit card account does not mean you have to use it and it is best to keep a zero or low monthly balance if possible.

We also recommend that your total debt balance not increase significantly when you take out the personal loan. For example, if you are paying off $10,000 in credit card debt, get as close to a $10,000 personal loan as possible and not a higher loan amount.

You may be able to afford a larger loan -- and the personal loan lender may push this option -- but we recommend that your loan amount matches the amount of debt you pay off because increasing your debt balance can be a negative when you apply for a mortgage.

Another important way paying down debt can help you qualify for a mortgage is if it reduces your total monthly debt expense. For example, replacing $500 in monthly credit card payments with a single $350 monthly personal loan payment significantly improves your debt-to-income ratio.

In short, the lower your monthly payments for debts such as credit cards and personal, car and student loans, the more you can afford to spend on your mortgage. So using a personal loan to consolidate high-cost credit card debt and reducing your total debt expense may enable you to qualify for a mortgage or afford a higher loan amount.

Use ourMORTGAGE QUALIFICATION CALCULATORto determine the mortgage you can afford based on your monthly gross income and debt payments

It is important to highlight that you should never apply for a personal loan -- or any other type of loan for that matter -- in between when you submit your mortgage application and when your mortgage closes as this may cause your loan to be delayed or rejected.

In closing, using a personal loan to pay off or down debt before you apply for a mortgage can be beneficial as long as you do it the right way.  Lowering your interest cost, possibly raising your credit score and reducing your total monthly debt expense can all help you qualify for a mortgage.

The table below shows mortgage terms for leading lenders near you.  We recommend that you contact multiple lenders to confirm the loan you can afford and to review their eligibility requirements.  Shopping lenders enables you to find the lender and mortgage that are right for you.

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Current Mortgage Rates as of February 17, 2020
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Data provided by Informa Research Services. Payments do not include amounts for taxes and insurance premiums. Click for more information on rates and product details.

Sources

Debt-to-Income Ratio for Mortgage: https://www.fanniemae.com/content/guide/selling/b3/6/02.html

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About the author

Harry Jensen, Mortgage Expert

Harry is the co-founder of FREEandCLEAR. He is a mortgage expert with over 45 years of industry experience. Over his career, Harry has closed thousands of loans for satisfied borrowers and now offers his advice and insights on FREEandCLEAR.  Harry is a licensed mortgage professional (NMLS #236752). More about Harry

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