Should you cancel your credit card before taking out a mortgage?

Starting the process of applying for a home loan can be as simple as contacting a bank or broker and going from there. But can prospective borrowers benefit from a bit more preparation?

There are certainly plenty of tips that borrowers can take on to improve their chances of getting a loan, including reining in their spending and building up their savings. But what action should people take when it comes to any existing credit card, or cards, they may have?

To better understand the impact that credit cards and other loans can have on a home loan application, we asked a lender and a mortgage broker for their insights.

Why do lenders need to assess a borrowers' existing debt?

"Lenders have to evaluate what we call the serviceability of a home loan, which is really based on an individual's ability to comfortably repay that loan over the entire term," explains Faith Brockhoff, chief customer officer at digital lender Tiimely Home (formerly Tic:Toc).

"Lots of factors are considered in that calculation, and existing debt - whether it's a credit card or another loan - does play a significant role in that.

"A key element of that is your debt-to-income ratio (DTI) which compares your debt repayments to your monthly gross income. Having a higher existing level of debt is likely to result in a lower approved loan amount or, in really severe cases if that DTI level is too high, the application being declined."

Are credit cards always considered debt by lenders?

Credit card holders who pay off their balances in full each month may be wondering if they even come into this conversation. After all, if there's no outstanding balance getting hit with interest charges each month it's not really debt, right?

Well, as Julian Finch, mortgage broker and founder of Finch Financial explains, that's not how lenders tend to view credit cards.

"People often get confused when they have a credit card but don't owe any money on it. Well, the bank you're applying for a home loan with doesn't care whether you owe money or not, they care about whether you could owe money.

"So it's not actually the balance that's the issue, it's the credit limit. If you've got a $10,000 credit limit that you owe nothing on, the bank will still consider that you owe $10,000."

How are credit cards viewed compared to personal loans?

While lenders will have to take into account any existing debt a borrower may have, Brockhoff says that credit cards and loans are viewed slightly differently.

"A credit card is really looked at as a revolving line of credit where you've got a credit limit and balances can roll over every month. And even though you might have a $6,000 credit limit and not actually be using that card, lenders have to assume that you're going to use that full $6,000.

"In contrast to that, personal loans or car loans, for example, are considered as installment debt as they generally have fixed monthly payments.

"The other thing is that the interest rates on credit cards are normally significantly higher than the interest rates on a personal loan. So you might have a higher outstanding debt on a personal loan, but the repayments for the credit card are higher because of the interest rate."

Can owning a credit card reduce your borrowing power?

In short, yes. As Finch explains, lenders tend to use a standard calculation to work out the impact that someone's credit card limit will have on their repayment capacity and the amount they can borrow.

Though he stresses that the figures will vary depending on other factors associated with each individual's application.

"They [lenders] have a fairly standard calculation where a $10,000 credit limit would be viewed as a $380 per month commitment in your budget. So 3.8% is the standard figure of the limit, and that's your repayment, essentially.

"So 3.8% of your limit is your monthly commitment. And it roughly works out to that for every $10,000 in credit limit, that will be about a $50,000 reduction in your borrowing capacity."

Is it worth cancelling a credit card before applying for a home loan?

Ultimately, keeping or cancelling a credit card before applying for a mortgage will be an individual decision. And it's a decision that may be influenced by how much someone is wanting to borrow, or how useful they find their credit card to be.

For Finch, it's a question worth asking though, and one that a broker or a lender can help guide borrowers through.

One alternative option that could provide benefits on both sides though is holding on to the card but reducing its limit.

"Where you can, and obviously this is not always going to be feasible for everyone, reduce the limit of your existing debts," says Brockhoff.

"So if you do have a credit card and you're not using that full limit, reduce it. Or pay off any other debts if you can, because lowering those debt amounts will help boost your borrowing power."

Three tips to improve your chances of being approved for a mortgage

Beyond credit cards, Brockhoff has three other tips for budding borrowers looking to increase their chances of successfully applying for a home loan:

1. Avoid taking on new debt

"It sounds obvious, but if you know that you're looking to get a home loan, don't go out and take out a car loan or a new credit card right before you're about to enter the home loan application stage. If you do need one of those, do so afterwards because they can negatively impact your application."

2. Cut back on your spending:

"If you can narrow your spending habits it can boost your chances of approval. Most lenders are going to ask some questions about your living expenses, and excessive discretionary spending can impact that. On this, I've seen buy now pay later trip people up before, because people aren't aware that it's often included in an application in a similar way to a credit card as an ongoing revolving line of credit. So that's just something to keep in mind that can impact your borrowing capacity."

3. Shop around lenders

"Comparing loan options and different lenders, particularly if you do have issues with existing or past credit issues, is really critical because lenders will have different criteria about what they can accept. It's also still a very competitive interest rate market, so you can potentially save thousands of dollars over the life of the loan. Each lender has unique criteria, so shopping around can help make sure that you get a loan that aligns with your financial circumstances and your goals."

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