Applying for a mortgage requires you to provide detailed information about your finances to your lender. Besides your employment history, income and assets, the bank will also want to know about your liabilities and expenses.
The lender needs to determine whether you can afford the payments on your mortgage. And, if you have too much debt to repay, including an outstanding car loan, there’s a risk your mortgage application could be rejected.
While borrowing money to purchase a vehicle may seem like a convenient solution, it can impact your ability to qualify for a home loan or reduce what you can borrow.
Why does a car loan affect my mortgage application?
Each lender has a set of criteria that borrowers must satisfy to qualify for a home loan. The goal is to minimize the risk to the lender. They want to be as confident as possible that you’ll be able to repay the loan and not default.
To assess your repayment capacity, lenders look at your income and assets relative to your debts and ongoing expenses, known as your debt-to-income ratio (DTI). The higher your DTI, the riskier you are to the lender.
Having a large car loan increases your DTI and reduces the amount of income left over to service a new mortgage.
Can a car loan reduce the amount I can borrow?
A car loan doesn’t necessarily stop you from qualifying for a mortgage. But it could reduce the amount you can borrow, forcing you into a less desirable property bracket.
According to LendingTree, the average car loan amount in the US is $34,635 for new vehicles, with an average monthly payment of $563. Let’s look at an example to see how that payment amount could impact a person’s mortgage borrowing ability.
Paul’s car loan
Paul Smith is a 32-year-old consultant planning to buy his first home. He earns $75,000 a year and recently took out a car loan for $30,000, with a payment of $608 a month for five years.
Paul has saved up $50,000 to put down on his first home. Based on this scenario, let’s look at how much Paul can borrow with the car loan and how much he could without it. These figures are based on a 30-year fixed-interest home loan at 2.866%.
With the $608 car loan:
- Mortgage amount: $228,000
- Monthly payment: $1,049
- Taxes, insurance and other fees: :$562
- Total payment: $1,611
Without the car loan:
- Mortgage amount: $320,000
- Monthly payment: $1,473
- Taxes, insurance and other fees: $748
- Total payment: $2,220
If Paul didn’t have the car loan, he could have borrowed nearly $100,000 more on his mortgage. So, as this example shows, if you’re planning on buying a house and want a higher loan limit, it’s advisable to borrow as little as possible for a car and keep your monthly debts to a minimum.
What factors do lenders assess in the home loan application process?
Banks generally offer home loans based on the following three questions:
- How much is your disposable income? The more disposable income you have, the better position you will be in to apply for a home loan.
- What is your credit history? Have you shown good conduct on previous and current loans such as credit cards, personal loans and utility bills?
- How much can you put down? The more you can put down for your home, the more likely you’ll get approved and attract a competitive rate.
Tips for improving your chance of approval
- Pay off your debts. While an outstanding car loan can hurt your borrowing power, a car loan that you’ve paid off can bolster your application.
- Reorganize your debts. If you’ve got multiple debts to manage, you may want to consider consolidating your debts into a single loan at ideally a lower rate.
- Have a consistent savings plan. Putting money into a savings account weekly or monthly demonstrates to a lender that you’re disciplined with saving money.
- Save a larger down payment. The larger the down payment you have saved, the less you’ll need to borrow and the more attractive your loan application will appear to a lender.
- Employment history. A stable and consistent employment history will improve your chances of approval. So, if you’re planning on applying for a home loan, it may be best to hold off changing jobs.
- Self-employed proof of income. If you’re self-employed, demonstrating a stable income can be more challenging. An accountant can help you put together your financial documents, which you’ll need to include as part of your loan application.
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While it can impact your borrowing power, a car loan doesn’t have to stand between you and homeownership. To find a home loan that fits your budget and goals, compare mortgage lenders and loan programs.