When you refinance or buy a home, prepare for an expensive process.
In addition to coming up with the down payment, you also have to pay closing costs that can add up to thousands.
It can be challenging to scrounge up money for the latter, especially if you're on a tight budget or this is your first home purchase. One option to cover your closing costs is a personal loan.
Depending on the interest rate charged, loan amount, and your ability to afford the payments, a personal loan could be a smart way to seal the deal and realize your homeownership dreams.
But a personal loan may not be your best choice for paying mortgage closing costs. Explore all the possibilities and weigh the plusses and minuses carefully.
What Are Closing Costs?
Closing costs are charges associated with purchasing a property that you typically pay by the transaction's closing date, Rajeh Saadeh, a real estate attorney in Somerville, New Jersey, explains.
"Closing cost fees can vary, depending on the amount of the loan, the property's purchase price, and the locality. But they typically amount to between 2% and 6% of the purchase price, often hovering under $5,000," he says.
Closing costs often include the following fees:
- Title search and insurance
- Property recording and transfer taxes
- Brokerage/agent commission*
- Mortgage application*, origination, and underwriting
- Home appraisal
- Home inspection
- Homeowners insurance
Budgeting for closing costs
"It's very common for refinancers and buyers - particularly first-time purchasers - to need assistance in paying for closing costs," according to Ralph DiBugnara, president of New York City-headquartered Home Qualified, a digital resource for buyers, sellers, and Realtors.
Kerri Moriarty, a Boston-based financial services business consultant, says it's important to be aware of closing costs up front so you can build them into your overall home-buying budget.
"Typically, buyers will come up with these funds from several sources, whether it's help from family or friends, borrowing from retirement accounts, finding a side gig, or using the time between an accepted offer and your actual closing to save," says Moriarty.
The U.S. Department of Housing and Urban Development website lists home-buying programs by state which may be of assistance.
If these sources Moriarty mentioned aren't viable, you may have to explore financing your closing costs. That's where a personal loan could help.
Financing Your Closing Costs with a Personal Loan
A personal loan can provide a quick and relatively easy way to get funds to cover your closing costs. Like all loans, it has its advantages and disadvantages.
"A personal loan could help you get into the home of your dreams faster," says Lauren Bringle Jackson, accredited financial counselor and content marketing manager at Self Financial in Austin, Texas.
Pros of personal loans for closing costs
"Probably the most obvious pro to using a personal loan is not having to come up with the money on your own and being able to get it fairly quickly," says Moriarty.
"Also, depending on your situation, sourcing the funds through a loan avoids any awkwardness that comes from borrowing from friends and family; you don't have to stress about repaying it or worry about the strain it could put on relationships."
There are a number of other advantages that fit on the "pro" side of the equation too:
- Personal loans don't require collateral
A personal loan is an unsecured loan, which means it doesn't require you to put up your property or another form of physical collateral to get the funds. It's often called a "signature" loan because that's pretty much all that is required -- your signature.
- Relatively simple and quick process
Personal loans are often easier to qualify for than other types of loans and financing options. Plus, you commonly get the money distributed to you quickly; that means you can apply pretty late in the game and possibly have funds for closing costs within a few days.
- Repayment timeline supports budgeting
Additionally, a personal loan provides ample time to repay the full amount -- usually 12 to 60 months or longer, depending on your lender and the loan's terms.
"You can repay the loan in structured, incremental payments that you can plan and budget for. And from the start, you can factor the monthly loan payment amount into your monthly mortgage expense and consider it that way as part of your budget," Moriarty adds.
Cons of personal loans for closing costs
But the convenience factors offered by a personal loan come at a price - typically in the form of a higher interest rate than you'd pay for some other kinds of loans.
"Depending on where you source the personal loan and your credit score and credit history, you may receive a less-competitive interest rate," cautions Moriarty. "This makes a personal loan arguably more expensive over its term than other alternatives like borrowing from loved ones or tapping a retirement account."
There are other drawbacks to consider on the "con" side of the equation:
- Increased overall debt
You're incurring more debt on top of the debt you'll already be responsible for with a mortgage loan.
- Increased budget complexity
"Plus, there's the added complexity to consider; having a personal loan with a monthly payment is just another expense to remember on top of everything else. You'll have to remember to make your personal loan payments each month," Moriarty says.
- Increased DTI ratio could disqualify you
Another concern mentioned by Suzanne Hollander, a Florida International University real estate faculty and Miami-based property attorney is that getting a personal loan could disqualify you for your purchase or refinance loan if it pushes you over your mortgage lender's allowable debt-to-income (DTI) ratio.
What is a Debt-to-Income Ratio?
Hollander explains that, during the loan underwriting process, the lender examines your income to verify that you earn enough money to repay the debt.
"Debts may include other loans such as student and auto loans, outstanding credit card balances, alimony, and child support, all of which you are required to list on your mortgage application," she says.
The lender then calculates your DTI to determine how much you can reasonably afford. It's calculated by taking your total monthly debts and dividing them by your total income, yielding a percentage value.
"A good DTI ratio is 36% or less," says Saadeh.
The maximum DTI for a conventional, qualified mortgage is 43%. Any number above 50% is considered too risky for a lender.
When considering your DTI, your lender not only scrutinizes what the number is today but how that number may change in the future, which helps determine the amount you are preapproved to borrow, Moriarty adds.
Again, acquiring a personal loan could hike your DTI to a number your mortgage lender may not be comfortable with, which may affect your ability to qualify for the home loan.
Jackson points out that mortgage lenders don't include costs like food, utilities, transportation, medical bills, and other common monthly expenses when calculating your DTI.
"That's why you need to add these other costs onto what you'll also have to pay each month so that you can decide if you can truly afford the loans you're being offered," says Jackson.
How Does a Personal Loan Affect My Credit Score?
Applying for a personal loan can also negatively affect your credit score in a couple ways:
- It will result in a hard inquiry on your credit report.
- It will impact your credit utilization ratio, which is the amount of revolving credit you're using right now divided by the total sum of revolving credit available to you.
"Creditors like to see your utilization ratio at around 30%," says Moriarty. "For example, if you have $10,000 of total credit available across all your credit cards and currently carry a $2,000 balance, you have a credit utilization ratio of 20%, which is great.
"But if you add a $5,000 personal loan, you now have $15,000 of total credit available and are using $7,000 of it; that yields a 47% utilization ratio, which will lower your credit score."
Remember: A lower credit score could result in paying a higher interest rate on loans, including a mortgage loan and personal loan.
When to Apply for a Personal Loan for Closing Costs
Moriarty recommends timing your personal loan application carefully.
"It's best to apply for a personal loan at the same time you're doing a credit check with your mortgage application or immediately after.
The closer together you ping your credit, the less risky it's perceived to be," she says. "The longer you wait, the more it indicates to a lender that perhaps you are having doubts about your ability to pay, which could be a cause for concern when it comes to underwriting your loan."
Saadeh cautions, however, that you won't be able to hide from your mortgage lender the fact that you applied for a personal loan.
"This will show up on your credit report if you apply for the personal loan before you apply for a mortgage loan," says Saadeh. "Also, the lender may require you to sign documents at closing that confirms you haven't sought or obtained any loans since the date of the credit check."
Alternatives for Financing Closing Costs
There are other ways to fund closing costs that may be preferable to a personal loan. "In a perfect world, the funds could be a gift from a friend or family member," Moriarty notes.
Assistance from the seller
Yet another possibility is asking the home seller to help.
"The seller may increase the purchase price by an anticipated amount of the closing costs and then give the buyer what is called a concession at closing in the amount of the increased purchase price," Saadeh notes. "That way, the seller is still getting the amount to which they and the buyer agreed, and the buyer is getting closing costs paid as a result of the seller's concession."
Assistance from the lender
It may also be possible for your lender to roll your closing costs into your loan balance or provide a "no-closing-cost" option whereby you are charged a higher interest rate on the loan.
Or, you may want to consider devoting some of your down payment funds (if possible) toward closing costs.
Postponing to save enough money
You could choose to postpone your refinance or home purchase until you've saved up enough for all associated expenses, including closing costs.
Less desirable alternatives
Lastly, you could withdraw emergency funds from a 401(k) or other retirement account, but this is rarely a good option because it really affects your retirement efforts.
"Best case scenario here is a Roth IRA. If it's been open for five years or more, you can pull out your contributions without penalty; and you can withdraw a max of $10,000, including investment earnings, without penalty from your Roth IRA if you are a first-time buyer," says Moriarty. "Other retirement accounts like a 401(k) usually allow you to borrow from your account at a low interest rate that you can pay back over time."