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Does Debt Consolidation Affect Your Ability to Buy a Home?

It is commonly known that a lot of debt can stand in the way of getting a good mortgage rate. And owing too much could prevent someone from getting a home loan at all. But what if you’re in the process of trying to reduce your debt payments? For example, does debt consolidation affect buying a home? 

There are different ways to consolidate debt, and each one can impact the ability to secure a mortgage loan. The key is to know what you’re signing up for, and how it might affect the factors that lenders look at when they measure your risk.

It is commonly known that a lot of debt can stand in the way of getting a good mortgage rate. And owing too much could prevent someone from getting a home loan at all. But what if you’re in the process of trying to reduce your debt payments? For example, does debt consolidation affect buying a home? 

There are different ways to consolidate debt, and each one can impact the ability to secure a mortgage loan. The key is to know what you’re signing up for, and how it might affect the factors that lenders look at when they measure your risk.

What Lenders Look for in a Borrower

Banks and mortgage lenders use a few variables to determine who qualifies for a mortgage and at what annual percentage rate (APR). 

  • Down payment amount. According to the National Association of Realtors (realtor.com), the median down payment is around 13% in 2023. The higher the down payment, the better the terms of the mortgage will be. Putting down 20% of the asking price is ideal for getting the best terms and avoiding costly mortgage insurance. 
  • Credit score. A lot of debt, late payments, and regularly paying only the minimum amount owed will hurt a person’s overall credit score. Lenders look for a credit score of at least 620 for a favorable interest rate, but would prefer to see 660 and up. 
  • Debt to income ratio (DTI). Lenders need to know that the amount a borrower owes (including a mortgage payment) is in line with what they make, with money left over to live on. Ideally, they look for a DTI of less than 36% and no more than 50%. Example: someone who makes $4,000 a month and has a mortgage, a car payment, and a credit card bill totaling $2,000 a month has a 50% DTI (2000 ÷ 4000 = 50%).

First-time homebuyers may qualify for government-assisted loans like FHA, VA, or USDA loans that require minimal down payments and may have more flexible terms. For conventional mortgages, however, the down payment, credit score, and debt-to-income ratio play the biggest role.

Choosing a Debt Consolidation Method

Unfortunately, debt happens. And owing a lot of money negatively impacts every one of the three factors that concern lenders. Potential homebuyers may turn to debt consolidation as a way to improve their credit and make them more appealing to lenders.

Debt consolidation takes all of a person’s various bills and combines them into a single monthly payment, preferably at a lower interest rate. The various original creditors are paid off in full and the person now owes the balance to just one entity.

The aim is not only the convenience of making one payment instead of several, but also the chance to pay off the total amount faster. This would seem to be just what lenders are looking for in a borrower. However, it can take some time for improvements to show up in the credit score and DTI depending on the method and timing of debt consolidation. Long story short, debt consolidation can help, but it won’t guarantee you’ll secure a loan.

The two most common ways to consolidate debt are loans and balance transfers:

1. Debt Consolidation Loans

Debt consolidation loans are personal loans. Long-term or open-ended debt can be consolidated into a shorter time frame of typically 1 to 7 years. For example, some student loans can take decades to pay off and it takes a long time to chip away at large credit card balances with high interest rates. 

The average credit card rate is more than 24% in 2023. While the average APR for a debt consolidation loan is 22%, shopping around can result in rates as low as 10%, even for someone with what is considered poor credit. 

If the borrower is diligent about making timely payments on the loan, they can build up their credit score while decreasing their overall debt load. This in turn improves their chances of securing a mortgage. 

One thing to watch for with any personal loan is loan origination fees. These can be pricey, temporarily adding back to the debt load. In the short term, this can potentially result in a higher mortgage APR. Consolidation lenders will do a credit inquiry during the application process. This too can make credit scores dip temporarily. Timing debt consolidation is important and we’ll discuss it in the next section.

2. Credit Card Balance Transfers

It’s not uncommon to have several different credit cards, and each will likely have a different interest rate. As we mentioned above, the national average rate is 24%. People can find a card with a lower interest rate and transfer their balances to the new card. Better yet, they can find one with 0% APR for a specified period of time. Then they can make an effort to pay off the balance within that period. 

One slight drawback of this method is that some cards charge balance transfer fees of about 3% of the total debt. Still, this is a way to pay less interest going forward, making it easier to eventually pay off the card. 

As for the ability to buy a home, as long as the monthly payments are reasonable, it can result in a debt-to-income ratio that is more favorable to mortgage lenders.

Image by Syda Productions by Canva.com

Debt Consolidation vs. Debt Settlement

Debt consolidation should not be confused with debt settlement. Debt consolidation with personal loans or credit card transfers is a way to lower monthly payments and accelerate payoffs. The total debt remains the same, it’s just been moved from one place to another.  

Debt settlement companies also collect payments from you and divide them up to pay your creditors for you (for a fee). The difference is that they also negotiate with your creditors to lower the total amount of your debt. 

Reducing the amount owed with debt settlement is not viewed by lenders in the same way as paying it off. In fact, it is often suggested as an alternative to declaring bankruptcy and can have a similar negative effect on the credit score, although not as drastic. Credit scores can take a hit of 200 points with bankruptcy. Debt settlement can lower it by 75 to 100 points, which is still enough to dash your hopes of getting a mortgage.

Debt Consolidation Should Be an Overall Strategy, Not a Quick Fix

Debt consolidation can definitely help a homebuyer improve their credit score and debt-to-income ratio—over time. But starting the process right before or during the house-hunting (and mortgage-hunting) process can be a mistake. 

Any hard inquiries into a person’s credit score will result in a short-term dip in the score. Hard inquiries can happen when renting an apartment, leasing a car, opening a new utility account, requesting a higher credit card limit, or opening a money market account. While the drop might only be 5 to 10 points, this could be enough to affect buying a house. It is best to wait for credit to bounce back which usually happens within a few months.

The best way to use debt consolidation is well in advance and as a part of an overall strategy to prepare for buying a house. This strategy should include deciding on a price range you can afford, saving for a downpayment, working out a budget for homeownership expenses, and fixing your credit if it isn’t ideal.

Do Your Homework When Balancing Debt and a Mortgage

Does debt consolidation affect buying a home? Paying off debt can be a good way to position yourself with lenders for a more favorable mortgage, and for many, debt consolidation is a good way to do that. But it isn’t a cure-all. How much of an impact it has will depend on the overall amount owed and how much consolidating will drop the debt-to-income ratio.

When consolidating, keep these tips in mind:

  • Choose the method that best suits your situation.
  • Create and stick to a strict budget to avoid adding more to your existing debt.
  • Don’t miss payments on your loan or new credit card.
  • Pay more than the minimum amount required when possible.
  • Make sure your home search is realistic with your budget and ability to borrow.
  • Consider FHA or other government-assisted options.

When you’re ready to buy a house, tackling debt can be challenging, but it isn’t impossible. Consider getting advice from a nonprofit credit counseling agency such as the National Foundation for Credit Counseling or the Financial Counseling Association of America. They can assist you in repairing your credit before you talk to mortgage lenders.

Contact the agents at Berkshire Hathaway HomeServices Select Properties, too. We partner with Nations Lending. Their team is ready to answer all of your mortgage questions and help you prepare for your house hunt. Together, we’re confident that we’ll find a home that fits your family’s needs!

Cover image by karamysh by Canva.com

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