One of the more important factors that lenders look at when assessing whether or not to approve you for a mortgage is your credit score. This important little number plays a key role in your mortgage application, and several things affect it, including various loan debt.
Depending on how you manage your loans, they can either make or break your credit score. Before you set out to apply for a mortgage, it’s helpful to look at how your existing loan debt impacts your rating.
Here are some of the more common consumer loans that play a key role in determining your credit score, and therefore your ability to secure a mortgage.
Among all household debt in the U.S., student loan debt is rising very quickly. In fact, more Americans are taking out student loans today, and they’re borrowing a higher amount as a result of skyrocketing tuition fees. Student loan debt is almost three times what it was a decade ago, and has reached the $1.3 million mark.
All that debt is possibly putting a damper on obtaining homeownership status. About one-third of Americans in their 20s owned a home in 2007, but that number has significantly dropped down to 21% as of 2016. If anything, student debt can at least explain a big part of this decline.
People with plenty of student debt will certainly be examined by mortgage lenders during the application process. Student loans – like other loan types like credit cards or car loans – will be assessed by lenders as a measure of the ability of a borrower to repay the mortgage. Like other forms of consumer debt, student loans can decrease the ability of an individual to borrow funds to finance a home because they shrink income.
Student loans are reported to the credit bureaus like many other loan types. They’re unsecured debt, which means they are not backed by any collateral. That said, they don’t necessarily have a negative effect on your credit score – that is, unless you fail to make your payments on time. And if these loans are allowed to linger on for years or even decades, they may make it harder to get approved for a mortgage.
Not only that, student loans will be factored into your debt-to-income ratio (DTI), so a massive student loan amount could affect your ability to be eligible for a mortgage.
Unlike student loans, auto loans are a type of secured debt, which means they are protected by collateral – namely, the vehicles that these loans are designed to finance. Sometimes having an auto loan on your debt portfolio can actually increase your credit score by diversifying the various debt types that you may have, as long payments are made on time and in full each month. If not, auto loan debt will have the opposite effect on your credit rating.
Sometimes a personal loan is needed to cover the cost of surprise expenses, such as paying for a car repair or a last-minute unexpected bill. Mortgage lenders must consider all of the monthly debt that people have. If they have personal loans added to the mix, that monthly payment will reduce the loan amount that would otherwise be qualified for when it comes to obtaining a mortgage. Essentially, having personal loan debt will affect how much a person would be able to qualify for.
A personal loan will essentially affect your debt-to-income ratio, which is a critical factor that lenders look at when assessing whether or not you would be eligible for mortgage approval. Basically, a DTI will provide some insight as to how likely you would be to default on your home loan payments.
Like other loan types, how you manage this added debt will have an impact on your credit score, which is a crucial factor that lenders will look at not just for determining whether mortgage approval would be granted, but also the type of interest rate you would be given. Basically, the better the credit score, the lower the rate.
If you’ve been making all your payments on time, that will have a positive effect on your credit score, and vice versa.
Payday loans aren’t typically reported to the credit bureaus, and as such, they likely won’t show up on your credit report. However, if you don’t make good on your payments, it will certainly be reported and could very well pull down your credit rating.
Many lenders view payday loans in a negative light because they suggest that you may have some potentially serious financial issues that would prompt you to borrow small amounts of funds at exorbitantly high interest rates. As such, this could be indicative of your inability to pay off a mortgage.
If you’ve already got a home loan and are looking to obtain a second one, your new lender will take a close look at your debt-to-income ratio to make sure you’ll be able to comfortably afford both mortgages each month. You will need to prove your ability to pay a second mortgage by supplying supporting documentation of income from various sources, including from your job, investment dividends, or rental income.
The Bottom Line
Having an active loan that you’re regularly paying down each month without missing a deadline can actually be a good thing for your credit. It shows potential lenders that you’re financially responsible and are fully capable of keeping up with your loan payments to stay on track to pay off the loan at some point. However, certain loans can do a disservice to your credit rating if you don’t manage them properly. Before you submit a mortgage application and begin your home search, make sure your debt situation is stable first.