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Keeping Score

Should I pay off my car loan before applying for a mortgage?

Paying off your auto loan could lower your credit score and keep you from making a large down payment

Summary

Paying off your car loan could lower your credit score – and prevent you from making a large down payment – since you will presumably have less cash on hand. Both of these factors can result in a higher interest rate, which would cost you more down the line.

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Dear Keeping Score,

My husband and I are looking to buy a house around early next year. We just had a baby, so I’m not going to go back to work full-time for about a year. Until that, we basically only have his income (around $63,000 a year).

We also have a car loan that we are paying $522 monthly and have around $26,000 left on. Our credit scores are in pretty good standing (my husband’s is in the high 700s and mine is above 800).

Would you recommend to pay off the car loan before we apply for our mortgage or rather keep the savings for a 20 percent down payment? Thank you for your answer! Have a nice day. – Dora

Check out all the answers from our credit card experts.

Ask Steve a question.

Dear Dora,

First, congratulations on your new addition. Now you are parents and soon you hope to be homeowners. Life as you knew it before will never be the same!

It seems your credit scores are in good shape, so that is great news. I don’t know what part of the country you live in, so it’s hard for me to gauge whether or not your husband’s income alone will suffice for the year you will be off, but for the purpose of my answer I am going to assume that you have thought of that and are prepared.

That being said, I would not suggest you pay off your car loan. There are four reasons for this.

Credit score impact

Strange as it sounds, when you pay off the loan your scores could go down. I know that doesn’t seem right, but you have to understand how the scoring models work. You have been paying on your car loan in a timely manner for a while now without any problems (I’m again making an assumption here, based mostly on your current credit scores).

But once you pay off the loan, your credit report will no longer show that you are able to make your monthly payments on time and as agreed.

In other words, the model won’t be able to take your current ability to service your loan into account. It will know you paid the loan off, but not if you have any cash flow available for your next potential loan situation. The history of on-time payments will remain on your report for years to come, but they will lessen in importance over time.

This differs from the credit score impact of paying off a credit card, which can raise your score by decreasing your credit utilization. However, installment loans don’t carry as much weight as revolving credit accounts under this category.

The amount that your scores may go down will depend in part on how long you have had a credit history. The longer the credit history, the less of an impact.

Since you’re just starting out in life, my guess is that you don’t have a huge amount of data in your credit files, so the impact to your scores will be more noticeable. However, they will recover in time. But you want to put your best credit foot forward as you begin the process of securing a mortgage in the near future.

Down payment impact

As you suggested, if you have the funds to pay off the car you already have enough to make a substantial down payment. The 20 percent you mention is probably a good guess for the minimum you will need.

As with any large purchase, the more you can put down, the less you will have to finance and the better terms you will qualify for. More money down means less risk for the lender if you should fall on hard times and they have to foreclose.

Less risk usually equals lower interest rates. In the long run – and a mortgage is a long-run proposition – you will save a lot of money in interest alone.

See related:  Is selling our house to pay off card debt a good idea?

Cash is king

You are going to find that certain expenses increase once you become a homeowner. This often comes as a surprise. The mortgage payment may be close to (or even a little less than) the rent payment you are accustomed to. But homeownership brings costs that many are not be completely prepared for.

You will no longer have a landlord who is responsible for expensive repairs, like when the A/C goes out in the heat of the summer. You will also be paying taxes and insurance on the property itself, which you have not had to do as a renter.

Chances are you will have more rooms than you have furniture. You can’t just leave a room empty, so you’ll be tempted to buy new furniture, rugs, etc.

See related:  5 steps to a mortgage-worthy credit profile

A baby is more expensive than a boat

In addition, you have a new family member that will need things – lots of things. In the beginning, family and friends help out a lot with baby shower gifts and the like, but that help will likely end long before your child’s needs will. In fact, you will find those needs will only increase as time goes by.

It looks to me as though you are planning ahead and doing everything right. Parenthood and home ownership have brought much joy to my own life, as I am sure they will to yours. Just know that you must expect the unexpected now more than ever. In my book, this equates to more money in the emergency fund.

For a young family, I’d shoot for at least six months of living expenses and as much as a year if you can manage it. And as for your financial life, pay your bills on time and be thoughtful when you take on new debt, and your credit score will grow along with your family. I wish you the best of luck.

Remember to keep track of your score!

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