How a Personal Loan Can Affect Your Mortgage Application

Does getting a personal loan affect your chances of mortgage approval? Personal loans can have good and bad consequences when you apply for a mortgage. Understanding the impact of personal loans before buying a house can make the process go smoother and help you avoid costly mistakes.

personal loan are neither good nor bad. They are just financial tools that can help you achieve goals. Here’s how a personal loan can affect your mortgage.

Personal Loan Applications Can Drop Your FICO Score

When you apply for any sort of loan, underwriters pull your credit report, which generates a “hard inquiry.” Every hard inquiry drops your credit score three to five points. This is important because the way mortgage loans are priced, dropping even a few points from your credit score could cost you hundreds or even thousands of dollars.

How your credit score can drop

For instance, Fannie Mae mortgages are priced in credit tiers — if you’re putting 20% down, you’ll pay .5% more in loan fees with a 690 FICO than you will with a 700 FICO. That’s an extra $1,000 for a $200,000 loan. You want to minimize the number of inquiries if you shop for a personal loan within months of getting a mortgage.

Fortunately, many personal loan providers can preapprove you for a loan and supply your interest rate quote without generating a hard inquiry. They gather information from various sources, and this preapproval only generates a “soft” inquiry, which does not harm your credit score.

You can shop for a personal loan with multiple providers and only create a single hard inquiry when you choose one provider and make a formal application.

Personal Loans Can Raise Your Debt-to-Income Ratio

When mortgage lenders evaluate a home loan application, the law requires them to ensure that you can afford the loan. The most common formula used by lenders is your debt-to-income ratio, or DTI.

Your DTI equals all of your monthly debt payments, including credit card minimums, auto financing, and student loans, plus your prospective mortgage payment, divided by your gross monthly income. Living expenses like utilities and food don’t count in the DTI.

Mortgage lenders prefer DTIs under 38%, but many will go as high as 41% and some all the way to 50%. A high DTI, especially if you have other issues like a small down payment or lower credit score, can make mortgage approval more difficult or more expensive.

How to figure out your DTI

Before taking a personal loan, multiply your gross (before tax) monthly income by .41 to see how much debt you can have while complying with mortgage underwriting guidelines. Subtract your desired house payment (including principal, interest, property taxes, and insurance) to see how much other debt you can have. If there is room in there for a personal loan payment, you can probably get away with taking one on.

For instance, suppose that your monthly before-tax income is $6,000. Multiply that by .41, and you get $2,460. Suppose the house you want would cost $1,460 for principal, interest, taxes, and insurance, which leaves you $1,000 for other debt payments. If your car loan, credit cards, and other expenses total $800, you can probably afford a personal loan with a payment of $200 per month.

Note that if you use a personal loan for debt consolidation, the payments for loans you consolidate will go away. So don’t forget to take them out when calculating your DTI.

Personal Loans for Debt Consolidation Can Raise Your Credit Score

When it comes to personal loans and mortgage applications, the news is not all bad. If you plan to apply for a mortgage in a few months and you’re carrying a lot of credit card debt, consolidating it with a personal loan can raise your FICO score almost instantly. That’s because of a formula called “credit utilization.”

How to determine your credit utilization

Credit utilization comprises 30% of your credit score. You can calculate yours by adding up all of your credit card balances, then adding up your credit limits (also called available credit). Divide the total balances by the total credit limits to see the percentage of available credit that you’re using — your utilization ratio.

For example, if your credit limits total $10,000, and your balances total $9,000, your utilization ratio is 90%.

Personal finance experts often recommend keeping your utilization below 30%, but people with the best credit scores tend to have utilization below 10%. By using a personal loan to clear all of your credit card balances, you can cut your utilization ratio to zero. Just make sure that your DTI stays within lender guidelines if you consolidate debt.

Personal Loans Can Increase Your Down Payment and Reserves

If buying a house is in your future, you’ll need money for closing costs, a down payment, and reserves.

Increasing your down payment can reduce or eliminate mortgage insurance premiums, which can somewhat offset the cost of borrowing with a personal loan.

And while most loan programs don’t allow you to borrow your down payment, the rules get a little fuzzy when personal loans are involved.

Using a personal loan for a down payment or closing costs

Personal loan providers allow you to borrow money for almost any purpose. Once they transfer the loan proceeds to your savings or checking account, the money is yours. After two or three months, the loan proceeds are mixed with your savings, paychecks that you deposit, and any other cash that comes in.

Once you have had the money for a few months, you apply for a mortgage and provide two or three months of bank statements showing that you have savings for a down payment, closing costs, and enough left over to make a couple of mortgage payments (reserves).

You will also have to disclose the personal loan balance and payment on your mortgage application. Before borrowing for this purpose, make sure the personal loan won’t push your DTI too high.

Personal Loans and Mortgages

A personal loan can affect your mortgage, but it depends on the rest of your financial picture. Personal loans are straightforward products, usually with fixed interest rates and payments. Personal loans for debt consolidation can improve your financial health in the long run by helping you clear debts faster, allowing you to get a mortgage in the future, and increasing your chances for successful homeownership.