Your Car Payment May Prevent You From Qualifying for a Mortgage

This illustration shows what factors may determine how much mortgage you qualify for including your total monthly housing costs compared to total monthly income and your debt to income.

Julie Bang / The Balance

Have you ever thought that you might have to make a choice between your new or nearly new car and owning your own home? Many first-time buyers are finding out the hard way that it's often one or the other: a car vs. a house.

What does your car payment have to do with qualifying for a mortgage? A lot, actually.

Understanding where a car payment fits in your financial picture can help you determine whether buying a home while managing a new car payment is in reach.

Key Takeaways

  • Before you purchase a brand-new car, consider the potential impact that the monthly payment could have if you need to qualify for a mortgage.
  • In general, your monthly payments (including your credit cards, car, and house payment) should not exceed 35% of your income.
  • If your car payment is too high, you might not be able to qualify for a large enough mortgage.
  • Consider buying a smaller or older vehicle to free up more room for your home purchase.

How Lenders Determine the Mortgage You Qualify For

Your credit score and finances influence whether you can get approved for a mortgage. Once you've got the green light on a loan, lenders use two simple ratios to determine how much money you can borrow.

Ratio #1: Total Monthly Housing Costs Compared to Total Monthly Income

Lenders want to see that you have enough income to keep up with the monthly expense associated with owning a home, so the first thing they consider is how much of your monthly income goes toward housing.

Here's how to calculate the ratio on your own:

  • Step 1: Write down your total gross pay per month, before deductions for taxes, and insurance.
  • Step 2: Multiply the number in Step 1 times .28 (28%).

This is the amount most lenders will use as the guideline for what your total housing costs (principal, interest, property taxes, and homeowners insurance, or PITI) should be. Some lenders may use a much higher percentage (up to 35%, but most people cannot realistically pay this much toward housing, and Ratio #2 often makes this a moot point).

Example for Ratio #1:

Suppose the combined income for you and your spouse is $70,000, or $5,833 per month. $5,833 x 28% = $1,633. Your total PITI should not exceed this amount.

Ratio #2: Debt to Income

Aside from what you're spending on housing, lenders also take into consideration your other monthly debt payments. Specifically, they consider your debt-to-income ratio.

Here's what you need to do to calculate it.

  • Step 1: Write down all of your monthly debt payments that extend more than 11 months into the future, such as car loans, furniture or other installment loans, credit card payments, or student loans.
  • Step 2: Multiply the number in Step 1 times .35 (35%). Your total monthly debt, including what you expect to pay in PITI, should not exceed this number.

Example for Ratio #2:

You and your spouse have credit card payments of $200 per month, car payments of $436 and $508 (see assumptions), student loan payments of $100 and $75, and payments of $100 per month for furniture you purchased on a revolving credit account and will pay off over a two-year period, for a total monthly debt payment of $1,419.

Multiply your total monthly income of $5,833 per month times .35 (35%). Your total monthly debt, including PITI, should not exceed $2,041. Subtract your monthly debt payments of $1,419 from $2,041. This leaves you $622 a month for PITI. Deduct your estimated taxes and insurance (see assumptions), and you're left with $386 per month toward principal and interest on a mortgage.

How Your Car Payment Can Keep You From Qualifying for a Mortgage

Under the above illustration, you'd qualify for a house that costs $61,000 (at 6.5% interest). Do you see the problem?

It's simple. There are very few places left in the United States where you can buy a house for $61,000. As of March 2020, the median sale price was $248,857, according to Zillow. A stiff car payment could be holding you back from qualifying for a larger mortgage.

Without them, you'd qualify for a mortgage payment (PITI) of $1,565 per month ($2,040 total allowable monthly debt payments minus your actual monthly debt payments, not including car payments, of $475). $1,565 minus property taxes, homeowners insurance, and private mortgage insurance, leaves $1,074 per month toward principal and interest payments.

That means you'd qualify for a house that costs approximately $169,000, which is much closer to the national median sales price.

Sidestepping the Choice Between a New Car and Owning a Home

You have to have transportation, so the point here is not to go without a car but to consider the impact of buying a new car on your ability to buy a house. The reason is so that you can plan ahead by making wise car-buying decisions.

Most cars depreciate in value very quickly, so buying a one- or two-year-old used car can save you between $5,000 and $15,000 (assuming the car cost $25,000 new). This would considerably improve your debt-to-income ratio and allow you to qualify for a larger mortgage while still allowing you to own nice, almost-new cars.

Buying the same make and model cars used in the above illustrations, but buying two-year-old cars instead of new ones, would give you car payments of $183 and $350 per month instead of $436 and $508, for a savings of $411 per month (not to mention what you'd save on auto insurance). You'd qualify for $65,000 more house, for a total of $128,000. You're much more likely to find houses for $128,000 than $61,000!

The Bottom Line

It's enjoyable (and tempting) to have new cars, but when you consider the trade-off between new and almost-new and the impact it has on your ability to buy a home or meet other financial goals, you have to consider whether it's truly worthwhile.

In the long run, buying a home may be the bigger goal of the two, and re-evaluating your car-buying plans may be necessary to make it a reality.

Assumptions Used in This Article for Illustration Purposes

One spouse has purchased a 2003 Toyota Tundra Truck with 4dr Access Cab SR5 4WD SB (4.7L 8cyl 4A) at a base price of $26,775, plus a Premium 3-in-1 Combo Radio w/CD Changer for $490, and an off-road package for $1,005, for a total price new of $28,270. The other spouse has purchased a 2003 Nissan Altima 3.5 SE 4dr Sedan (3.5L 6cyl 4A) with a base price of $23,149, plus a sports package (power sunroof and rear spoiler) for $1,249, for a total of $24,398. These car prices are close to the average car price paid in 2002.

Perhaps you have excellent and substantial credit and qualify for a low interest rate of 4.5%—your credit score affects your interest rate. Your car loans are for five years and assume you paid $1,000 down on each car, resulting in payments of $436 for the Nissan Altima and $508 for the Toyota Tundra.

If you buy a two-year-old Nissan Altima instead of a new one, the average price will be around $10,400 instead of $24,398 and your monthly payment will be around $183 at 6.3% interest and $1,000 down. Interest rates on used cars are generally somewhat higher than rates on new cars.

If your spouse buys a two-year-old Toyota Tundra truck instead of a new one, for $19,000 instead of $28,270—Toyotas don't depreciate as quickly as American cars—your monthly payment will be around $350 at 6.3% interest and $1,000 down.

Your property taxes are $2,000 per year, or $166 per month, and your homeowner's insurance is $300, or $25 per month. You can't make a down payment equal to 20% of the value of the house you're buying, so you'll also have to pay private mortgage insurance, estimated at $45 per month.

Frequently Asked Questions (FAQs)

How do you qualify for a car loan?

For a car loan, lenders consider your credit score, income, and whether you're making a down payment and/or trade-in. You don't need perfect credit to qualify, but you'll get a better interest rate if you have good-to-excellent credit.

Does leasing a car affect your debt-to-income ratio?

A car lease will affect your debt-to-income ratio much like a car loan. The payment counts in your total debt payments, which are compared to your gross income to determine your debt-to-income ratio. Lease payments are typically lower than loan payments, but at the end of the lease, you'll either need to buy the vehicle, turn in the vehicle and walk away, or start a new lease on a different vehicle.