Experts say not to apply for credit before buying a house. But does this apply to car loan refinancing?
Refinancing your car can help you snag a lower interest rate and a lower monthly auto loan payment. But depending on your credit history, refinancing your car right before buying a home can impact your mortgage application.
If you’re not sure what to do first — buy a home or refinance your car loan — here’s what to think about.
What Do Lenders Look for When Approving a Home Loan?
Let’s quickly discuss what lenders look at to approve you for a mortgage:
Your credit score
Mortgage lenders use your credit score and credit report to determine if you’re creditworthy. A high credit score means you’re less likely to default, so people with high credit scores are often rewarded with application approvals and better interest rates. The opposite is true for people with low credit scores.
These are the factors from your credit report that are considered in your FICO Score calculation:
- Payment history (35%): a measure of whether you pay your debt on time
- Amounts owed (30%): a review of how much debt you owe
- Length of credit history (15%): how long you’ve been managing credit
- Credit mix (10%): the mix of debt accounts you have
- New credit (10%): new credit inquiries
The minimum credit score needed for a mortgage varies by mortgage type and program, but in general, you need a credit score of at least 620. If your score could use some work, there are ways to improve your credit, though it may take some time.
Your income and employment
Lenders review your income and employment status to ensure that you have a stable source of income to repay the mortgage. To verify your income, the lender might ask for tax records and pay stubs.
If you’re self-employed, you may need to provide two years of tax statements including all schedules.
Your debt-to-income (DTI) ratio
Lenders use your income and debt to calculate your debt-to-income ratio, which is a percentage that expresses how much of your monthly income goes to paying off debt. Using this ratio, lenders determine the mortgage payment you can afford given your current debt responsibilities.
DTI requirements vary, but generally, mortgage lenders look for a DTI of 43% or less.
(DTI) Debt-to-Income Ratio Calculator
Your debt-to-income ratio, or DTI, is a percentage that compares your monthly debt payments to your gross monthly income.
Many auto refinance lenders have a maximum DTI of around 50%. However, if you're applying for a mortgage, lenders prefer a DTI under 36%.
To calculate your DTI, add up your debt payments for each month (including the proposed mortgage payment), divide that total by your monthly income, and multiply by 100.
Example A: Calculate Your Debt-to-Income Ratio
Pre-tax income: $5,000
Credit card minimum: $250
Student loan: $500
Auto loan: $500
Mortgage payment: $840
Total debt payments: $2,090
To calculate your DTI, divide your total monthly debt payments ($2,090) by your pre-tax income ($5,000) and multiply by 100.
$2,090 ÷ $5,000 x 100 = 41.8%
4 Ways Car Loan Refinancing Might Affect Your Mortgage Approval
Now that we know what matters in the mortgage application process, here’s how car loan refinancing might impact your approval.
1. The hard credit inquiry could hurt your score
The process of applying for car loan refinancing usually includes a credit check, and it will likely count as a hard inquiry against your credit profile, which can dock your score a few points.
After a credit hit, “You might not qualify for a [mortgage] rate you thought you did before,” said Benjamin Schandelson, a loan originator with MJS Financial LLC in Boca Raton.
The degree to which a hard credit inquiry will hurt your score varies. According to FICO, a hard credit check might reduce your FICO score by as little as five points since the “new credit” factor of your score only has a 10% weight in the calculation.
That said, the hit could be greater for certain people: A hard inquiry might be more impactful if you have few accounts on your credit report and a short credit history.
2. The lender might ask for more paperwork
Car loan refinancing is essentially opening up a new loan account to pay off your existing auto loan. If a new loan pops up on your report before applying for a mortgage, the lender might ask for a letter of explanation as to why you opened the new account.
3. Refinancing in the middle of buying a home could prolong mortgage closing
Making major changes to your debt accounts while in the process of buying a home — such as refinancing a car loan or putting a major purchase on your credit card — means your monthly debt payments might change and the DTI might need to be recalculated. This could stall the closing process.
4. The refinance could lower your DTI
Plot twist: Refinancing your car loan before buying a house might not only negatively affect your future home purchase. A refinance loan that lowers your monthly payment could also reduce your DTI.
Let’s say that refinancing your car loan dropped your monthly car payment from $500 to $350 in the example above. Here are the new numbers:
Example B: Calculate Your Debt-to-Income Ratio After Refinancing
Pre-tax income: $5,000
Credit card minimum: $250
Student loan: $500
Auto loan: $350
Mortgage payment: $840
Total debt payments: $1,940
To calculate your DTI, divide your total monthly debt payments ($1,940) by your pre-tax income ($5,000) and multiply by 100.
$1,940 ÷ $5,000 x 100 = 38.8%
Pros and Cons of Refinancing a Car Loan Before Buying a House
If you’re trying to decide whether or not it’s a good idea to refinance your car before buying a home, here are some pros and cons.
- Lock in a better rate on your car loan: Let’s face it, finding the perfect home can take months or even years. Refinancing before house hunting instead of putting it off could help you enjoy car loan savings while you search for the right house to call home. Plus, you could put the monthly savings towards the home down payment, closing costs, and other mortgage-related fees.
- Reduce your DTI: Lowering your payment isn’t just nice to your wallet, a lower monthly car payment might decrease your DTI ratio, which could help you qualify for a better mortgage.
- The credit hit might be minimal: If you have decent credit, the car refinance might have minimal impact on your credit.
- The credit hit could be greater in some cases: FICO states that people with few accounts and a short credit history might see more of an impact from credit inquiries. If you have a thin file or several hard inquiries already on your account, another credit check before applying for a mortgage could hurt your approval odds and interest rate.
- Lower payments don’t always equal savings: The lower monthly payment you might get after refinancing could be caused by extending the loan term, which might mean you pay more over the life of the loan. Be sure to compare the total cost of the new loan to your existing loan.
- Car loan refinancing isn’t free: The new lender may charge loan origination fees to process the loan and your current lender might even charge a prepayment penalty fee when you pay off the current loan early. These costs could eat away at your potential savings making the process more hassle than it’s worth ahead of a home purchase.
Does It Ever Make Sense To Refinance Your Car Loan Before Applying for a Mortgage?
It depends on your financial situation. “If you can qualify for a mortgage with your current debt and income, we suggest waiting until after buying a home to refinance your car,” said Schandelson.
The one circumstance where car refinancing might actually be beneficial before a home purchase is if you have a high credit score and a high DTI, according to Schandelson. That’s because refinancing for someone who has strong credit could lower the DTI without causing too much of a credit hit.
How Long Should You Wait To Purchase a Home After Refinancing?
Schandelson recommends waiting for at least one or two payments into the new auto loan refinance before buying a home. This might take two to four months depending on the terms of the loan.
As far as credit score recovery goes before homebuying, the effect of a hard inquiry might only last a few months for people with good credit. So, if your score is, say, 800 or higher, the handful of points you lose after the credit check could have a minimal impact and you might be ready to buy a home fairly quickly.
For homebuyers with less-than-perfect credit, the hard pull could affect you for up to a year. Ultimately, how long you decide to wait to buy a home after car refinancing depends on factors like your credit, but also external factors like mortgage rate trends and the housing market.
Mortgage rates are low at the moment, even for borrowers without perfect credit, so that could motivate you to buy sooner than later. A financial advisor or real estate agent can give you advice on when the right time is to buy given your circumstances and market conditions.
Refinancing Your Car After Buying a House: Is It Possible?
Yes, it’s possible to refinance your car after buying a home. In fact, you might find that auto lenders are a bit less stringent with qualifying criteria than mortgage lenders.
For example, you might be able to qualify for car loan refinancing with a DTI as high as 50%, but DTI requirements can also vary from one lender to another.
If you’re not able to get approved for car loan refinancing that has a competitive rate with one lender, you can always shop around for rates with others. Consider shopping with banks, credit unions, and alternative lenders to see what each type of financial institution has to offer you.
Ready, Set, Explore Your Options
The best way to figure out whether you should refinance your auto loan or buy a house first is to start comparing different scenarios. You might be able to speak with lenders and pre-qualify for loans with just a soft inquiry that doesn’t affect your credit. Based on the preliminary offers you get, you can make a decision on what will be the right move for you.
About The Author
Taylor K. Medine is a personal finance writer covering money management topics and finance products. She's written for finance publications such as Credit Karma, CompareCards, and MagnifyMoney. She runs the blog TayTalksMoney, which discusses how Millennials and Generation Z can live an abundant life on a tight budget.