We want to buy a home in the coming year, but we desperately need a new car. Will it look better to mortgage lenders if we lease a car? Or, is buying a car a better financial option?
Debbie, MMI Reader
The typical new car loan costs $530 per month, while the average new lease costs $430 per month, according to an Experian report from the third quarter of 2018. And, that’s expected to increase. In fact, The Federal Reserve Bank of New York reported that auto debt increased $17 billion in the second quarter of 2019.
These numbers are important because lenders consider them when qualifying mortgage borrowers for a loan. Not only that, but auto loans and auto leases are not viewed as the same.
Your debt-to-income ratio and auto financing
One of the first things lenders check for mortgage applications is your debt-to-income (DTI) ratio. This confirms whether borrowers can reasonable afford all of their monthly costs in addition to the loan payments.
Typically, lenders like to see a DTI of 43% or less, though there are exceptions. If you have a $9,000 per month household gross income (before taxes), then 43% equals $3,870. This is the allowable budget for recurring debt payments such as student loans, credit card payments, and auto loans as well as new monthly home costs like your mortgage payment and homeowners insurance.
It might seem as though auto debt, plus mortgage costs are affordable for such a household. But, many households often need more than one car. All of a sudden car payments are a much larger monthly expense and, in some cases, a cost big enough to undermine your DTI ratio.
Net worth, car leases, and auto loans
If it comes down to DTI, it may seem as though car lease payments and car loan payments are the same for purposes of a mortgage application. That’s no so. Even if you have a $450 monthly car loan payment and a $450 a month auto lease payment, these are seen differently by mortgage lenders.
A lease payment is essentially rent. At the end of the lease term, your equity in the vehicle is zero and your net worth does not increase. You also have decisions to make once the lease ends.
- You can lease another vehicle.
- You can buy the vehicle you’ve been leasing.
- You can buy another vehicle.
These choices have one quality in common. They mean your need to make monthly payments will continue unless you’re able to buy a car for cash.
With an auto loan the situation is different. Each monthly payment gives you more equity in the vehicle. After the loan is paid off the car is yours. It’s an asset to you. Also, once a vehicle is paid off there’s no monthly payment to count against your DTI ratio.
When car payments are not considered a debt
While car lease payments are always considered a debt for DTI purposes, that’s not always true with car loans. They may not count against you even if you pay out big money each month.
“Lease payments,” says Fannie Mae, “must be considered as recurring monthly debt obligations regardless of the number of months remaining on the lease. This is because the expiration of a lease agreement for rental housing or an automobile typically leads to either a new lease agreement, the buyout of the existing lease, or the purchase of a new vehicle or house.”
The story with auto loan payments is different.
Under Fannie Mae and Freddie Mac rules lenders can ignore monthly auto loan costs if 10 or fewer payments remain.
Does leasing a car affect your credit score?
Whether you lease or buy a vehicle can greatly impact your credit score.
With a lease, you have a monthly payment obligation. When the lease ends, there’s likely to be either a new lease or a new monthly cost for a vehicle purchase. In either case, credit utilization is increased and that can reduce your credit score.
Pay off a recurring loan and your credit utilization declines. Often your credit score goes up too. And, higher credit scores can mean lower mortgage rates and easier loan applications.
Government-backed loans and auto leases
Government-backed loans like FHA, VA, and USDA loans have their own underwriting rules and each view auto leases and loan payments differently.
FHA mortgages and auto leases
According to HUD, with FHA-backed loans “closed-end debts do not have to be included if they will be paid off within 10 months and the cumulative payments of all such debts are less than or equal to 5 percent of the Borrower’s gross monthly income.”
While some loan programs will allow you to pay down debts to lower DTI percentages the FHA does not. Its rules state that “the Borrower may not pay down the balance in order to meet the 10-month requirement.”
VA mortgages and auto leases
With VA loans the approach is different. The VA says debts and obligations with fewer than 10 remaining payments can be ignored for DTI purposes. But, it also says that lenders must include “accounts with a term less than 10 months that require payments so large as to cause a severe impact on the family’s resources for any period of time.”
Confused? You bet. To clarify matters the VA gives this example.
“Monthly payments of $300 on an auto loan with a remaining balance of $1,500, even though it should be paid out in 5 months, would be considered significant,” says the VA.
Why? Because “the payment amount is so large as to cause a severe impact on the family’s resources during the first, most critical, months of the home loan.”
USDA mortgages and auto leases
With USDA loans the debt-to-income calculations must include “long-term obligations with more than ten months repayment remaining on the credit report presented at underwriting.” Loans with fewer remaining payments can be excluded.
Next steps for buying a car and applying for a mortgage
For specific advice on your situation, then it’s best to speak with a professional mortgage loan officer. In some cases, it may make sense to delay refinancing or house hunting for a month or two. It may allow one or two more car payments to be ignored when computing your debt-to-income ratio — and that’s an application plus.
