Should you consolidate debt before buying a home?

Homeownership is a big goal, and it feels great to walk away from the closing table with keys in hand. If you have credit card balances or other debts, it's natural to wonder how that might affect your odds of getting a mortgage. 

You might wonder whether debt consolidation will help or hurt your chances. Consolidation has advantages and disadvantages, which could influence your decision to combine debts. 

Read on to learn how debt consolidation may affect your home-buying plans. 

Is it a good idea to consolidate debt before you apply for a mortgage?

Debt consolidation could help you get a home loan if it reduces your debt-to-income (DTI) ratio and lowers your monthly payments. On the other hand, consolidation could also cause a temporary drop in your credit scores, which might hurt your application. 

It's common to think about debt consolidation before you apply for a mortgage. After all, you want to make yourself look as attractive as possible to a lender, and reducing your debt load is one way to do it. If you lack the cash to pay your debts in full, then consolidation may be the next best solution. 

When you consolidate debt, you combine multiple debts into one, usually through a loan. For example, you might get a personal loan and use it to pay off your credit card balances. That would leave you with only the loan to pay off. 

Debt consolidation won't reduce what you owe, but it could make it easier to manage. And that's a good thing if you want to persuade a lender to give you a sizable mortgage. 

Debt consolidation could help you qualify for a mortgage

Lenders care about how much of your money is available to pay a mortgage each month. We mentioned the DTI ratio, but let's explain what that means. 

Debt-to-income measures how much of your gross income goes to debt repayment each month. To calculate your DTI, you add up all your debt payments and divide them by your gross pay (your pay before taxes). 

For example, if you pay $1,500 per month to student loans, credit cards, and medical bills and your gross pay is $5,000 per month, your DTI works out to 30%. You can use a debt-to-income ratio calculator to do the math.

Mortgage lenders typically prefer a DTI up to 36%, and that's with your estimated mortgage payments included. Some lenders may accept borrowers with a DTI up to 50%, but that's less common. 

Debt consolidation could reduce this ratio if your new monthly payment is less than what you paid to your existing debts. How does it work? Let’s say you owe $25,000 in credit card debt. Your monthly mortgage payment is $1,600, and you bring in $5,000 a month. That's a DTI of 48%.

If you were to consolidate that into a lower-interest loan at 18% with a five-year payoff, your monthly payments would drop—and so would your DTI ratio. Let's crunch the numbers:

That $165 difference in your monthly debt payment would drop your DTI from 48% to 45%. That could be enough of a decrease to help you qualify for certain types of mortgage loans.

Debt consolidation could help with the right loan terms

Debt consolidation, whether it's before you apply for a mortgage or any other time, could help you streamline payments, but the numbers need to make sense. Your loan terms determine:

• How much you pay monthly

• What consolidation will cost in interest

• How quickly you clear the debt

Your interest rate and repayment term both affect your payment amount. A lower interest rate is a positive, but if you choose a longer term, you could still pay more interest overall. 

A shorter term, meanwhile, could reduce the amount of interest you pay even if you don't lock in the lowest rate. However, it could push your monthly payments higher, which can affect your DTI ratio. 

Prequalify with trusted lenders to get a sense of what you might pay for a debt consolidation loan. You can crunch the numbers with different interest rates and terms to understand how the monthly payments add up, and what you might save, if anything. 

Risks of consolidating before applying 

Applying for a debt consolidation loan right before you apply for a mortgage could hurt you in a couple of ways. Many of the impacts can be seen through your credit scores. 

When you apply for loans, lenders pull your credit reports and scores. That pull shows up as a hard inquiry on your credit report—inquiries count toward 10% of your FICO credit score calculation. 

A new inquiry could trim a few points off your credit scores, which doesn't sound like much but every point could count for a large mortgage loan. If your score puts you right on the border between fair and good credit, for instance, then even a few points could make a difference. 

Besides that, new accounts can reduce your overall credit age, which measures how long you've been using credit. Account age counts toward 15% of your FICO Score, so you risk losing points by opening a new loan before getting a mortgage. 

How to decide if debt consolidation is the right move

Should you consolidate debt before buying a home? It's a personal decision, and there are a few factors to weigh before you make a move. 

• Check your DTI. Calculate your DTI if you haven't yet to understand how much of your income goes to debt payments. You can do this by adding up all of your monthly debt payments and divide that amount by your gross income for the month. You'll need your DTI for the next step. 

• Get rate quotes. Rate quotes from prequalification aren't guaranteed offers for a loan, but they can give you an idea of what your interest rate and payments might be. You can compare the estimated payment with the payments you're making now to calculate if consolidation would reduce your DTI. 

• Talk to a mortgage specialist. A mortgage advisor can walk you through the pros and cons of debt consolidation before you apply for a home loan and what impact, if any, the timing might have. If you already know where you want to get your mortgage, you can reach out to them. Otherwise, your current bank could be a good place to start. 

Your main choices for personal loans for debt consolidation are banks, credit unions, and online lenders. Online personal loans could offer faster approval times, quicker funding, and more generous loan terms, so don't be afraid to check them out. 

What's next

• Review your debts and monthly budget to understand what you pay now, and what that means for your DTI.

• Check your credit reports and scores to find out what factors are working in your favor, or against you. 

• Plan your timeline for consolidation and applying for a mortgage. You want to reach both goals with as little negative impact on your credit as possible.