Buying a new or slightly used car and purchasing a home are two of the biggest financial steps we make in our lives, but did you know one could affect the other?
When you apply for a car loan, the size of your monthly payments and how well you maintain those payments can factor into your mortgage approval. Here’s what you need to know before you take on these big purchases.
An auto loan can have a big impact on your credit score, which in turn has a big impact on whether you will get approved for a home loan and what rates you will get.
First, when you apply for an auto loan, the inquiry will appear on your credit report and lower your credit score temporarily.
“If you have very good credit, there is probably nothing to worry about,” said Peter Grabel, a mortgage loan originator for Luxury Mortgage Corp. “However, if the inquiries reduce your score from a 701 to a 699, for example [below the lender’s credit threshold], it could impact your mortgage rate.”
How you manage your auto loan will also affect your credit score. If you make your payments on time, your score will go up. If you miss a few payments, you will hurt your chances of getting a home loan.
Lenders use your debt-to-income ratio (or the amount of your monthly debts versus your take-home pay) to determine your ability to repay your mortgage. Under the new qualified mortgage rules, your monthly debts—including your auto loan—cannot exceed 43% of what you bring home. If your auto loan pushes you above the limit, you may not qualify for a home loan.
When you apply for pre-approval on a mortgage, lenders will compare your debt-to-income ratio and housing expenses such as property taxes and insurance to determine how much you can borrow for a home. If you have a large car payment to make each month, it will lower your borrowing power.
“A $430 auto payment [could] reduce your mortgage borrowing power by $100,000,” Grabel said.
With less borrowing power, you’ll have less money to work with and may have to opt for a smaller or cheaper home if you cannot raise the additional funds yourself.
Timing big purchases
“If you are planning to apply for a mortgage in the near future—six months or less—you should avoid applying for any type of credit if possible,” said Grabel, since taking on a large loan can affect your credit rating and your debt-to-income ratio.
And don’t confuse a pre-approval with a finalized mortgage.
“Your credit will be monitored up to the day of closing,” Grabel said. “If this new debt causes your ratios to go over the limit, your loan may be jeopardized, even if you were previously approved and cleared to close.”
Using car loans to build credit
While taking on a car loan will have an impact, it could be a positive one if you have limited or poor credit. If you take on a car loan six to 12 months before applying for a mortgage and make timely payments, your credit score will increase.
Also, “Mortgage lenders typically like to see at least three active trade lines,” Grabel said.
If your credit is limited, having a well-managed auto loan works in your favor.