Will a Personal Loan Affect a Mortgage Application?

Used strategically, a personal loan can help your mortgage application.

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When you're applying for a mortgage, any debts you have -- auto loans, student loans, credit cards, and personal loans -- can affect how much you can borrow and whether you can qualify for a mortgage in the first place.

When lenders look at your mortgage application, the most important thing isn't necessarily your credit score or credit history, but whether you can afford the monthly payments in the first place. To that end, your monthly payments on any non-mortgage debts are a vital piece of the puzzle.

How personal loans affect your mortgage application

Mortgage underwriting standards vary by bank and mortgage program, but all lenders will evaluate your "front-end debt-to-income (DTI) ratio" and your "back-end DTI ratio." Your front-end DTI ratio is the percentage of your monthly gross income that you spend on housing expenses, and most mortgage lenders want it to stay below 28%. Your back-end DTI ratio is the percentage of your monthly gross income that you spend on housing expenses plus all debts combined, and it typically needs to be under 36% if you're trying to get a mortgage.

From a lender's perspective, housing expenses include monthly payments for principal, interest, taxes, and insurance (collectively known as PITI). Any homeowner's association dues, if applicable, are also included.

So if you earn $60,000 per year in gross income, your monthly gross income is $5,000. Thus, to qualify for a conventional mortgage, your monthly payments for the home (PITI plus any HOA dues) would have to be less than $1,400 per month ($5,000 x 28% = $1,400).

In addition, you would also have to spend less than 36% of your gross income on all your debts, including housing costs. If you earned $5,000 per month, then you could spend no more than $1,800 per month combined on housing costs (PITI plus HOA dues) and payments on other debts like credit cards, student loans, or personal loans.

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In this example, the difference between the front-end ratio (maximum monthly housing costs of $1,400) and back-end ratio (maximum monthly payments on all debt of $1,800) is $400 per month. This tells us that you can have up to $400 per month in non-housing debt payments before they start affecting the potential amount of your mortgage. After the first $400, each additional dollar spent on non-housing debt payments would reduce how much could be spent on housing costs.

Borrowers who have large non-housing obligations typically turn to other types of mortgages to buy a home. For example, FHA mortgages, which are designed for first-time homebuyers, have relaxed requirements and allow for front-end ratios (housing costs only) of up to 31% of the borrowers' gross monthly income and back-end ratios (all debt payments) of 43% of the borrower's gross monthly income. Of course, these mortgages come with trade-offs; namely, they require you to pay for mortgage insurance, which will increase the total cost of the mortgage.

How to improve your mortgage application

There are a few ways you can "game" the system to allow you to qualify for more money with a mortgage by tinkering with your debts to get a favorable debt-to-income ratio.

• Pay off small debts. This is a good way to eliminate monthly payments and be able to afford a bigger mortgage. A credit card with a $600 balance might require a minimum monthly payment of $25 per month. While it may seem small, eliminating a $25-per-month obligation would free up about $4,700 of borrowing capacity on a 30-year mortgage with an interest rate of 5%. At the margin, that's a big difference, especially if you have a handful of these balances to eliminate.
  
  

• Pay down large debts. Lenders only count non-housing debts if they are expected to be paid for 10 months or more. So if you have 18 months of payments remaining on a $300-per-month car loan, consider paying roughly half the balance in advance so that you only have nine months remaining on the balance.
  
  

• Refinance debts. Extending the amount of time you have to pay off a debt can reduce your monthly payments, albeit at the cost of additional interest. For example, refinancing a two-year loan of $5,000 at a rate of 6% into a three-year personal loan of $5,000 at the same rate will reduce your monthly payment by about $70 per month. The disadvantage is that you'll pay off the loan more slowly and thus pay more in interest (about $158 in this case). This isn't ideal, but it works as a quick fix if you can't afford to pay off the debt right away.

A personal loan can help you achieve any of these three things. You could use a personal loan to consolidate several different credit card balances, likely reducing your combined monthly payments. You could also use a personal loan to extend the repayment terms on another loan, giving you more time to make payments, but potentially at the cost of paying more in interest.

Can a personal loan help you get a mortgage?

A personal loan can help you qualify for a mortgage in some cases, but it won't be an overnight solution. Using a personal loan to refinance high-interest debts like credit card debt or even other personal loans can be a good idea. By reducing the interest rate, you can pay down debt faster, which will help you get on better footing to buy a home.

Using a personal loan in any other fashion isn't likely to help. In theory, you could get a personal loan, put the cash in a high-yielding savings account, and later use it to pay for the down payment on a mortgage. In practice, though, it's typical for banks to require that the money you use for a down payment has been "seasoned" (read: sitting in your bank account) for 60 days or more.

Beyond that, banks will look at your credit applications in the past three, six, or even 12 months. If you applied for a personal loan six months ago, and your bank account ballooned around that time, it's likely they'll rule out using that money as a down payment on a mortgage.

A mortgage is a huge commitment to repay hundreds of thousands of dollars over the course of 15 to 30 years. For that reason, aside from paying down any consumer debts you have or increasing your income, there aren't many overnight ways to become eligible for the mortgage you want.

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