Consolidating your debts is a powerful way to manage your finances, especially if you have access to low-interest-rate consolidation loans while your current loans have high interest rates. Debt consolidation is also particularly helpful if you’re juggling several different payments with different payment dates.
However, as with any type of loan product, taking on a loan to consolidate your debt will affect your credit score, overall financial health, and of course, your ability to take out a mortgage. Before you click away from this article, just know that depending on your situation, a debt consolidation loan could actually help you qualify for a mortgage.
In this article, we’ll cover everything you need to know about
debt consolidation loans and how they affect the mortgage qualification process!
Understanding debt consolidation
When you’re consolidating a debt, you’re essentially combining multiple existing loans (such as credit cards, personal loans, or even
student loans) into a single loan with one monthly payment. People consolidate their debts for a variety of reasons, whether that be to get a lower interest rate, a longer loan term, or just to simplify their finances. Two common ways that people consolidate their debts are through taking out a personal loan, or using a balance transfer credit card.
As we mentioned before though, debt consolidation can impact your eligibility for a home loan, since mortgage lenders take a look at several different factors when evaluating your eligibility, like recent credit inquiries, outstanding total debt, and most importantly, your debt-to-income ratio, also known as your DTI.
Debt-to-income ratio and mortgage approval
Your debt-to-income ratio is quite possibly the most important metric that a mortgage lender will look at when evaluating your credit worthiness. The DTI is used as a tool to measure whether or not you’ll be able to afford your monthly mortgage payment. To calculate your debt-to-income ratio, you simply divide your total monthly debt obligations (the sum of all minimum monthly payments on all installment loans, like credit cards, student/personal/auto loans, etc.) and divide that number by your total monthly income.
The DTI is typically represented as a percentage, and generally speaking, when applying for a mortgage, you want your DTI to be as low as possible. Oftentimes, when shopping for a home, people may find that their DTI is slightly too high to finance the house that they want. However, if they have debts that they can consolidate or refinance, doing so can actually help them afford the home of their dreams. By consolidating or refinancing debt to either extend the term or lower the interest rate (i.e. lower your monthly payment), you can lower your DTI without having to pay off your debts!
Your credit score and home buying
Unfortunately, debt consolidation both relies on and affects your credit score, which as many know, affects your eligibility for a mortgage. When applying for a debt consolidation loan or mortgage, the lender will look at your credit report, triggering a hard inquiry. Hard inquiries will slightly bring down your credit score in the short term. This means it’s often best to wait until your mortgage lender has run your credit before applying for a debt consolidation loan.
However, if you’re consolidating credit card debt, a debt consolidation loan can help you reduce your credit utilization and avoid missed payments. This, in the long run, will help to increase your credit score. Additionally, as we discussed in the previous section, a debt consolidation loan can also help you afford that home of your dreams. So, the long-term benefits to both your credit and lifestyle often outweigh the short-term detriments.
Types of debt consolidation options
Different types of debt often require different approaches to consolidation. For instance, unsecured debts, like credit cards and personal loans are typically consolidated through a personal loan, or transferring the balances to a balance transfer credit card.
For homeowners or property owners with significant equity in their real estate, a home equity loan or line of credit is often a great option. Since these types of loans are secured by a piece of real estate, they often come with lower interest rates than balance transfer credit cards or personal loans.
If you have a lot of high-interest debt or a low credit score that keeps you from qualifying for these options, there are several
debt relief options, like
debt settlement or
credit counseling. However, the latter two options often have a severely negative impact on your credit score, which will delay your plans of buying a home.
Is debt consolidation right for you?
Before you consolidate your debt, it’s important to take a look at your overall financial situation and goals. Consolidating debt is a big decision to make and can have impacts on your life for years to come. That’s why it’s important to ask yourself questions like:
Are the costs of consolidating my debt worth it?
Will consolidating my debt put me in a better financial situation?
Will I be able to afford my new loan and a mortgage?
While homeownership is the goal of countless people across the country, being realistic with your current financial situation is paramount. If you just barely qualify for a mortgage after consolidating your debt, you should think long and hard about how taking out that mortgage will affect your lifestyle and overall financial health.
After all, you don’t want to put yourself into a situation where you can barely afford to pay your monthly debt obligations. Sometimes, renting for a few more months while you save up some additional funds for your down payment is a great option. There are plenty of houses out there on the market, and it’s much better to let one get away than to put yourself in a financial predicament!
The bottom line
Consolidating your debts is a powerful way to make homeownership more accessible and improve your overall financial well-being. Lowering your interest rates, and monthly debt obligations is a great way to free up money each month, so you can pay for the home of your dreams. However, you should be self-aware and ensure that you’re not using debt consolidation loans as a way to overextend yourself just to afford a home.
