Debt consolidation is a smart move, especially when you’re dealing with high-interest loans or multiple monthly payments. With debt consolidation, you can easily simplify your finances and, in fact, improve your overall financial health and credit score. Do you know Experian states that individuals who consolidate debt observe an average credit score increase of 20 points in just a matter of 3 months leading to decrease in credit utilization? Many individuals choose debt consolidation before they plan to invest in purchasing a new home. This is because if you have a bad credit score or you’re in some form of debt, it may often become difficult for you to apply for a home loan.
When you choose debt consolidation, it lowers your debt-to-income (DTI) ratio, eventually resulting in setting your credit score on the upside and improving your overall chance of getting a mortgage approval. On the other hand, if you have debts, it can hurt the repayment period or monthly payments, which may work against you. So, how do you navigate debt consolidation while preparing for homeownership?
Let’s learn everything we know.
How Debt Consolidation Impacts Your Credit Score?
Debt consolidation can surely impact your credit score in negative and positive ways. However, the positives definitely outweigh the negatives. Let’s say you apply for a new loan, and that too for something like a house. It can send out a hard inquiry prompt for the bank issuing the loan to check your credit history. The inquiry is conducted by a professional auditor who checks how much existing debt you have on loans you have taken out for multiple reasons over time. Besides, when you take out something as big as a house loan, this loan is usually issued to you through a new account, which makes up at least 10% of your FICO Score.
With every new account you open, this percentage adds up to your existing debts, and from there onwards, you can improve your score by making sure you’re sending out timely payments. With debt consolidation, this loan and multiple others are submerged into one big loan for which you can pay monthly payments as one. This credit utilization ratio that you have amassed over time will considerably decrease, securing your FICO score overall.
For those of you who aren’t aware of what a FICO score is, it’s a credit score through which a lender checks your creditworthiness. FICO scores are analyzed in more than 90% of loan takeouts and U.S. lending decisions. Lenders usually take a look at your FICO score to ensure you are trustworthy enough to pay your bills on time. When you have a bad FICO score, it impacts your eligibility and may affect other areas of your life negatively.
How is the FICO Score Calculated?
FICO scores are calculated based on your previous credit reports, which include:
- Payment history (35%)
- Amounts owed (30%)
- Length of credit history (15%)
- Credit mix (10%)
- New credit (10%)
FICO score is a 3-digit number, and a good FICO score is somewhere around 670. If it’s higher, your creditworthiness is much better.
How Debt Consolidation Works with Mortgage Approval
When you apply for debt consolidation, it reduces your debt-to-income ratio. A lowered debt-to-income ratio ensures you receive your mortgage without much hassle. The exact requirements for how much your debt-to-income ratio should be depend on the loan type you’re planning to receive. If you’re planning to take out a conventional mortgage, the requirements for getting approval would be:
- Down payment of at least 3% to 5%
- 620+ credit score
- DTI ratio of 50% or less
Consolidation debts often have lower interest rates, which means that you may have to pay lower monthly payments. As a result, when you apply for debt consolidation, you get a chance to lower your DTI ratio overall. Consolidation can also increase your DTI ratio when you opt for debt consolidation for a shorter period and choose higher monthly payments. Therefore, when you choose debt consolidation to take out a mortgage loan, it’s normally advised that you apply for consolidation for a maximum tenure so you have the lowest monthly payouts. Just make sure that there are no prepayment penalties or anything of the sort before you take out a loan for your home.
What to Consider Before Debt Consolidation for a Home Loan
There are a few things you need to consider when you opt to take out a debt consolidation option for a mortgage loan. Here are a few things you need to keep in mind:
- Check Your Credit Score: Before you go for debt consolidation, check your credit score as it will help you learn whether you’re eligible for qualifying for a mortgage loan or not. At the same time, it will also help you get the best rates and choose the right terms for consolidation today.
- Becoming Pre-qualified: Most companies that provide you the chance to take out debt consolidation also offer you to “check your rate.” It helps them analyze available monthly payments and sophisticated loan terms before you go ahead and apply.
- Old vs. New Monthly Payments: Compare your old monthly payments with your new monthly payments after you take out a debt consolidation loan. See how much of a difference you will be paying; in fact, you can compare it with your individual loans and sum it up to check if you’re getting any benefit or not.
- Determine DTI: Add up everything—your monthly debt payments, your monthly gross income—and check what your DTI ratio is. If your DTI falls within the range of a loan approval, then go for it. Otherwise, you will only be adding more burden to your existing loans.
Types of Debt Consolidation & Mortgage Implications
The most common type of debt consolidation is one which involves personal installment loan. While, there are other loan types which work on this purpose, consider how different debt consolidation loan impacts one’s ability to get an approval on mortgage.
Personal Loan
Personal installment loans come with fixed interest rates, fixed monthly payments, and have a predecided repayment terms. These terms cannot be changed once the loan disbursement takes place. Choosing a lower monthly payment on your personal loan will lower your DTI and improve your overall chance to qualify for a mortgage loan. However, with too many personal loans, your debt consolidation loan can result in higher monthly payments which can altogether, lead to more difficult situation for qualifying.
Balance Transfer
Balance Transfer applies 0% APR on balance transfers for an overall tenure of up to 21 months. However, there’s a small fee that you will have to pay. People often transfer debt to another credit card with zero interest to lower credit utilization ratio. However, to get the best results, people often leave their debt credit card’s account opening balance to $0 to maintain a very low credit utilization ratio.
Home Equity Loan
Do you currently have a home and you’re looking for a considerable home equity? You may consider borrowing money for debt consolidation for a home equity loan that places your house as collateral. Most lenders only offer you 85% of the amount to borrowed off the original price of the home equity also including the primary mortgage amount.
How Lenders Evaluate Mortgage Application with Debt Consolidation?
Lenders take a look at multiple factors, especially when it comes to taking out mortgage application, including things such as regular income, your existing credit score and your down payment amount. They also check your debt-to-income (DTI) ratio & as long as you’re meeting the minimum mortgage eligibility requirements, they will continue with the process.
Conclusion
In conclusion, debt consolidation can be an effective strategy for improving your financial situation and increasing your chances of securing a mortgage. By reducing your debt-to-income ratio and boosting your credit score, it creates a more favorable financial profile for homeownership. However, it’s important to carefully assess your options and ensure that the consolidation plan aligns with your long-term financial goals. By taking the time to understand the impact on your credit and mortgage approval, you can make a well-informed decision that benefits you in the long run.
If you’re ready to take control of your debt and work towards a brighter financial future, consider exploring your options with Mountains Debt Relief. Let us help guide you on the path to financial freedom and homeownership.