Most people dream of buying a house. But you often need to overcome a mountain of debt before reaching this goal. If your ongoing debt is hindering your ability to qualify for a mortgage, then it’s recommended to consolidate your debt so that you are in a better position ahead of the mortgage lender. If you are a first-time home buyer, then it’s obvious to have doubts regarding the effect of debt consolidation on your chances of homeownership.
Whether debt consolidation inflicts a positive or negative effect on your home buying ultimately depends on the timing. It is bound to induce a negative impact if you plan on consolidating your debt right before buying the home or during the process. Applying for a loan or line of credit requires a hard credit inquiry and debt consolidation can result in a short-term drop in your credit score. It can also temporarily increase your overall debt load and hurt your credit score due to a credit card balance transfer fee or loan origination fee. A lower credit score can lead to thousands of dollars in costs if it causes you to get a higher mortgage APR than your normal course of action.
If you carry out debt consolidation well in advance of your home buying, then it is going to get easier to receive good mortgage approval as you combine your debts into one balance with a lower APR. You can also decrease your overall debt load and increase your history of timely payments by waiting until you pay off most of your balance. Both these factors will help improve your chances of getting a home loan with excellent rates. As your existing debts get paid off quicker, you will even be able to buy a home sooner.
Thus, you must have already understood why it’s better to wait for a few months till your credit score gets back on track rather than immediately buying your home after getting a new credit card or loan for consolidation. Today we will discuss different factors to consider when trying to schedule a debt to consolidate around a home mortgage application.
- Hard inquiry – A hard inquiry is conducted into your credit history when you apply for a balance transfer credit card or debt consolidation loan. This leads to a fall in your credit score by 5-10 months for a few months making it difficult to get a good mortgage.
- Greater credit utilization – Your credit utilization ratio may go up on consolidating your debts into a new credit card. This can negatively impact your credit score and make it difficult to get approval for a home loan.
- Increase in debt load – The amount owed by you at the beginning can go up by 8% from fees associated with some types of debt consolidation. Some credit cards might charge fees on balance transfers and often loans charge origination fees for account opening. This is an important factor for lenders who consider total debt load while evaluating home loan applications.
- Debt reduction and score improvement in the long-term – Debt consolidation has negative effects in the short-term but boosts your chances of home buying on consolidating months or years before the purchase. This will build a solid payment history and also reduce your debt load which can help improve your credit score.
Types of debt consolidation
Debt consolidation comes in different forms and today we will take a look at five of them:
Balance Transfer
Certain credit card issuers provide balance transfers either at a low-interest rate or 0% interest. You can avail of them to consolidate multiple debts into one credit card. This rate is applicable for a certain period like 12 months following which the no or low-interest rate offer ends. Usually, a fee is charged by credit card issuers for balance transfers. Your credit score and ability to get a home loan won’t be affected if you accept a balance transfer through an existing credit card. This happens as your balance gets shifted from one card to another.
But if you open multiple credit card accounts, then your credit score might reduce. You can take advantage of a low-interest rate offer by applying for a new balance transfer credit card but this will cause your credit score to temporarily decrease. The main reason behind this is that your application will cause a hard inquiry on your credit report. As you pay off the balance transfer debt, your credit score will increase again.
401(k) Loan
Your credit score won’t be directly affected if you take out a loan against your employer-sponsored 401(k) retirement plan. On consolidating your debt, your credit score can increase as your overall owed amount gets reduced. As a result, it will become easier to obtain a home loan. However, your retirement fund might get depleted and you might miss out on investment gains as you borrow money from your 401(k).
Personal Loan
This can be a lucrative proposition if the interest rate for the loan is less than the overall interest rate. The main motive of this type of loan is to reduce your debt burden and increase your credit score. But to benefit from the same you should make timely payments. It’s imperative to note here that applying for a personal loan can lead to a “hard” inquiry and temporarily lower your credit score. Your ability to get a home loan might get seriously hampered in the long term if you can’t make timely payments or fail to repay at all.
Credit Counseling
Your home buying plan might or might not be affected as you work with a non-profit credit counseling service. The interest rates on your debt will most likely be lowered if a credit counselor puts you on a debt management plan. This can lower your overall payment when compared to paying different debts at once. You can build a positive payment record and pay off your debts in this way to boost your credit score. Ultimately, this will increase your likeliness of getting the best terms for a home loan.
With an ongoing debt management plan different credit bureaus won’t be notified by the credit counseling agency and thus this won’t appear on your credit report. However, you will have to close your credit accounts upon enrolling in such a plan. You could still qualify for a mortgage if your debt-to-income ratio, credit history, and credit score are decent enough. However, you need to understand that the interest on a mortgage will be more when going through a debt management plan.
Debt Relief
If you are trying to improve your finances, then this can be especially helpful. However, your credit score and ultimately your home-buying ability might be affected if you are settling a debt for less than the full amount. This is a still better option than not paying the debts. Debt relief can induce a positive impact on your mortgage application.
How Does Debt Consolidation Affect Mortgage Loans?
Your debt-to-income ratio might improve depending on which debt consolidation method you choose. This is one of the key factors considered by mortgage lenders while reviewing your application. A low ratio signifies that borrowers are at risk of missing loan payments while a higher ratio means that you are at a higher risk of skipping loan payments.
A debt-to-income ratio is computed by the mortgage lender after comparing how much you own each month with the money you are borrowing each month. The lender will look at different debts like monthly house or rental payments, monthly child support, alimony payments, minimum monthly payments for credit cards, auto loans, student loans, and other monthly loan payments, to compute this formula. A debt-to-income ratio is shown as a percentage with 43% being the highest ratio allowed to qualify for a mortgage.
How To Prepare For A Home Purchase After Debt Consolidation?
- Primarily, you need to save enough funds to make the down payment. This is ideally 6% of the loan value. You need to have ample cash on hand so that the lender can trust your financial shape.
- One of the best means of increasing your savings is cutting down on spending. This will help allocate more funds toward making the down payment and moving a step closer to qualifying for the mortgage.
- You should try and boost your credit score as you gear up to buy a home. This can be attained by making timely bill payments and slashing your debt even more.
- It’s wise to examine your financial habits like whether you are relying too much on credit cards or paying only the minimum amount each month on your credit card. Correcting the mistakes can increase your chances of homeownership.
- Last but not least, you should set up a budget to strike the right balance between income and spending.
Conclusion
The proper debt solution can reduce damage to your financial future from things like foreclosure and bankruptcy. Debt consolidation is one of our first defenses against the outcomes of severe financial distress. When applying for a home loan, it’s best to have the lowest pre-existing debt and the highest credit score of 620+. A debt-to-income ratio of 36% or less and no more than 50% is recommended when buying a house. You might want to buy a house immediately after debt consolidation but it’s best to consolidate your debts in advance for credit improvement and reduction in existing debt load.