You’re sitting across from your loan officer, refinance application in hand, and they’re frowning at your debt-to-income ratio. Your DTI is borderline, and that car loan isn’t helping. “It’s close,” they say. “Have you thought about paying off that car?”
You hadn’t. But now you’re wondering: should you drain your savings to clear the car loan and improve your DTI before refinancing? Or is that just creating a different problem?
The answer isn’t what most people expect.
The DTI Math That Drives This Decision
Your debt-to-income ratio is the percentage of your gross monthly income that goes toward debt payments. Lenders use it to decide if you can afford another loan. For most conventional refinances, maximum DTI limits typically range from 43% to 50% depending on the lender, loan program, and compensating factors like credit score and reserves.1 The lower your DTI, the better your rate—and your approval odds.
Here’s where the car loan enters the equation: every dollar of monthly car payment counts against you. A $400 car payment on $7,000 monthly income is roughly 5.7% of your DTI. That might be the difference between approval and rejection, or between a 6.5% rate and a 6.875% rate.
So the logic seems clean: pay off the car, drop the DTI, get approved or get a better rate. And sometimes, that’s exactly right.
But only sometimes.
The Hidden Cost Nobody Mentions: Liquidity
When you pay off a car loan early, you’re converting liquid cash into an illiquid asset. Your savings account shrinks. Your emergency fund disappears. You’re house-rich and cash-poor before you even finish the refinance.
This matters because refinancing comes with costs—appraisal fees, title fees, potentially points if you’re buying down the rate. If you’ve already drained your reserves to kill the car loan, you might not have enough left to close. Or worse, you close but have nothing left for the water heater that dies two weeks later.
Lenders also care about reserves. Depending on the loan type, property type, and your overall risk profile, they may require anywhere from zero to twelve months of mortgage payments in reserves after closing—with two to six months being common for conventional conforming loans.2 If paying off the car wipes you out, you might improve your DTI but fail the reserves test. You’ve solved one problem by creating another.
The real question isn’t whether paying off the car improves your numbers. It’s whether it improves your position.
When Paying Off the Car Actually Makes Sense
There are situations where this move is genuinely rational.
First: you’re barely over the DTI threshold, and you have enough cash to pay off the car and still maintain healthy reserves. Let’s say you have $25,000 in savings, the car loan balance is $8,000, and paying it off drops your DTI from 45% to 39%. You’re still left with $17,000—more than enough to cover closing costs and have a cushion. That’s a clean trade.
Second: you’re refinancing into a lower rate, and the savings from the refinance are larger than the interest you’re paying on the car. If your car loan is at 3.5% and your refinance saves you $200 a month, you’re not giving up much by clearing the car early. The opportunity cost is low.
Third: the car loan is almost paid off anyway. If you’ve got three payments left, just finish it. There’s no strategic reason to keep a dying debt alive when it’s messing with your refinance approval.
But outside these scenarios, paying off the car often creates more problems than it solves.
The Situations Where This Backfires
The most common mistake: draining your emergency fund to improve your DTI, then getting approved for a refinance you can’t actually afford to maintain.
Let’s say you pay off a $12,000 car loan to get your DTI from 48% to 42%. You get approved. Great. But now you have $2,000 left in the bank, and your refinance costs $4,000 to close. You’re borrowing from family or putting closing costs on a credit card, which defeats the entire purpose of improving your debt position.
Or consider this: you pay off the car, get approved, close the refinance, and two months later your HVAC dies. You can’t cover the $6,000 repair because you spent your savings clearing a 4% car loan. Now you’re taking out a personal loan at 11% or opening a credit card you can’t pay off. You’ve traded low-interest debt for high-interest debt, all to pass an underwriting test.
The other trap: paying off a car loan that’s at a lower rate than what you’d earn by keeping the cash invested. If your car loan is at 2.9% and you could leave that money in a high-yield savings account at 4.5%, you’re losing money by paying off the car early—even if it improves your DTI. The math doesn’t care about your feelings.
And then there’s the timing issue. Some people pay off the car months before applying for the refinance, thinking they’re getting ahead. But if rates drop or your situation changes, you might not refinance at all—and now you’ve given up liquidity for no reason. Paying off debt is irreversible. Refinancing isn’t guaranteed.
The Alternative: Adjust the Refinance, Not the Debt
If your DTI is too high to qualify, paying off the car isn’t the only option. You could refinance into a longer term, which lowers your monthly payment and reduces the DTI hit. You could skip the cash-out and do a rate-and-term refi, which keeps your loan balance lower and improves your ratio.
Or you could wait. If you’re six months from paying off the car naturally, just wait. Your DTI will improve on its own, and you won’t have to blow up your cash position to force it.
Some people assume lenders are inflexible, but they’re not. If you’re close to the DTI threshold, ask your loan officer if there’s another path. Maybe you can get a co-borrower. Maybe you can exclude certain debts if they’re about to be paid off. Maybe you can shop a different lender with looser guidelines.
Paying off the car is the nuclear option. Explore the conventional options first.
The Simple Rule of Thumb
Here’s the decision framework:
If paying off the car leaves you with at least six months of expenses in liquid savings after closing costs, and your car loan interest rate is higher than what you’d earn keeping the money in cash, then pay it off.
If paying off the car drains your reserves, or if your car loan rate is lower than your savings yield, don’t do it. Find another way to improve your DTI or accept that you might not qualify right now.
The worst outcome isn’t getting rejected for a refinance. It’s getting approved for one you can’t sustain because you gutted your financial cushion to pass underwriting.
What Happens After You Pay It Off
Assuming you do decide to pay off the car, the next move is critical: get proof. Lenders won’t take your word for it. You’ll need a payoff letter from the auto lender showing the balance is zero and the lien is released. This can take weeks. If you’re in a rush to close the refinance, that delay might kill the rate you were trying to lock.
Also, your credit report won’t update instantly. Paying off the car today doesn’t mean your DTI improves tomorrow in the eyes of the lender. They’ll need documentation. They’ll verify the payoff. They might still count the payment until the loan officially reports as closed. Plan for lag time.
And once it’s done, you can’t undo it. If the refinance falls through because of an appraisal issue or an underwriting surprise, you’ve still spent the money. You don’t get that liquidity back unless you take on new debt—which puts you right back where you started, or worse.
The Bigger Question You Should Be Asking
Paying off the car might get you the refinance. But if you’re that close to the edge on DTI, should you be refinancing at all?
A refinance isn’t free money. It resets your mortgage clock, extends your payoff timeline, and locks you into a new rate for years. If your finances are so tight that a $400 car payment is the difference between approval and rejection, maybe the issue isn’t the car loan. Maybe it’s the mortgage you’re trying to refinance into.
Before you drain your savings to improve your DTI, ask yourself if this refinance is actually improving your financial position—or just your monthly cash flow. If it’s the latter, you might be solving the wrong problem.
And if you’re refinancing to pull cash out, consider whether taking on more debt while eliminating liquidity is really the move. A cash-out refinance already increases your loan balance. Paying off the car to qualify for it might get you approved, but it also means you’re walking into a bigger mortgage with less cash on hand. That’s not a stronger position. That’s a more fragile one.
The car loan isn’t the problem. The question is whether the refinance is the solution.
Footnotes
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DTI requirements vary by loan program. Conventional conforming loans backed by Fannie Mae generally allow up to 45-50% DTI with strong compensating factors; FHA loans may allow higher ratios. Always confirm with your specific lender and loan program. ↩
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Reserve requirements are not standardized and depend heavily on loan type (conventional, FHA, VA, jumbo), occupancy (primary vs investment), loan-to-value ratio, credit profile, and lender overlays. Some programs require no reserves; others may require 12+ months for higher-risk scenarios. ↩