Should You Pay Off Your Car Before Buying a House?
Next to a mortgage payment, a car payment is often the second largest monthly payment for many people. With the recent increases in both new and used car prices due to inflation, monthly car payments keep growing. Whether you’re a first time buyer or thinking of upgrading your current home, you’ll need to find out how your car payment will affect your loan qualification.
Everyone’s finances are different, and there is no one right answer when deciding how large of a car payment you can handle along with a mortgage payment.
Here are some common questions about car payments as they relate to mortgage loan approval.
How does a car loan affect your debt-to-income ratio?
Your debt to income ratio considers all fixed and variable monthly debt payments compared to your monthly income. Each loan program generally has a maximum debt to income ratio – meaning you can only spend a certain percentage of your monthly income on housing payments, installment loans, auto leases, credit card minimums, and other recurring monthly debt obligations. This means the more expensive your housing payment is, the lower every other payment will need to be to stay below the maximum debt to income ratio.
For example, if the maximum debt to income ratio is 50% and you make $5000 per month, lenders will cap your combined monthly debt payments at $2500. If you have no other debt, you may be able to spend that entire amount on a housing payment. If you have a $500 car payment and $200 in credit cards, that only leaves $1800 month for your mortgage, property taxes and home insurance.
How could paying off a car loan impact your down payment on a home?
If you find that there aren’t enough homes priced within your budget, you may need to consider paying off your car loan to afford a larger mortgage. Depending on your auto loan balance, this may or may not be feasible. If you just took out the car loan, the balance may be all or most of your down payment budget. Paying off the loan could leave you with an empty bank account and no funds for your down payment, closing costs, or reserves. You may need to come up with another source for your down payment, or start looking for homes in a less expensive area.
Important Tip: If a loan needs to be paid off, you can often pay it off at closing. It does not always need to be paid off in advance. If you have the funds available to pay off a loan in your bank account, ask your loan officer for guidance on how to handle the payoff.
How should you weigh the benefit of lowering your DTI against the drawback of having less cash reserves?
This is a question you should be asking your loan officer. Because each person’s scenario will be different from the next, it’s really important for your loan officer to look at the whole picture, including your credit report. What type of loan is best considering your credit score, available down payment funds, and long term goals? If you only need a small down payment, you may have plenty of funds left to pay off a car loan. If you have minimal funds with a strong income, your car loan may not have as much of an impact on qualifying.
Can you refinance your car loan to lower your payment?
If paying off the loan is not an option, but you’ve paid down the balance over the past few years, a refinance may be the best way to get a lower monthly car payment. Remember to keep all paperwork showing your old loan being paid off, along with your new car loan agreement. This will be needed to document your new monthly payment and exclude your old monthly payment.
Can you trade in your car for a cheaper car?
If you have the opportunity to trade in your expensive car for a more budget friendly option that will lower your monthly payment, this could be a good move. Reducing your payment is the next best thing to eliminating your payment.
If I lease my car, can I end my lease to help qualify for the home instead?
An auto lease counts against your monthly debt just about the same way as an installment loan. If your lease is ending, however, lenders will assume you’ll either start a new lease or buy a new car. This is different than when you have one or two payments left on an auto loan, because you will own your car when the loan is paid off. You can certainly buy out your lease and purchase your car if you have the funds. Once your car is owned outright, your monthly payment will no longer be counted. Unless you have another paid off vehicle available to use, buying out your lease is the only way to exclude an auto lease payment.
Is it a good idea to buy a car before applying for a mortgage?
Unless you’re stranded and have no way to get to work, it’s generally not a good idea to buy a car before applying for a mortgage, because it will likely reduce your purchasing power. Again, every situation is different, but most people are negatively affected by adding a new car loan payment to their monthly debt.
If you find yourself shopping for a car and a home at the same time, it’s always going to be best to close on your new home before starting the car buying process. Doing this will give you the most options in your home search. For your financial well being, keep in mind that you’re eventually going to need to budget for a car payment, but ultimately you should hold off on any other large purchases until you’ve closed on your home.