You've asked (or implied) a lot of semi-related questions about how your finances will impact your loan costs. In order to answer them, it may help to step back and consider the bigger picture about mortgage decision making.
Banks generally want to know four things when it comes to approving a mortgage loan:
- Is the property good collateral? A mortgage is a secured loan, the house you're buying is collateral against the loan. As such, the bank will take steps to make sure the collateral has an appropriate value compared to the loan - they'll likely want it to pass inspection(s), and have an appraised value appropriate for the price you're paying. That isn't the focus of your question, so we can assume this factor is not an issue.
- Does the borrower have cash on hand to support the immediate costs for the purchase? You'll need a downpayment, closing costs, etc. - generally, the bank will want to see proof that you have this cash on hand. This is also secondary to your question, so again we'll assume you're OK here.
- Does the borrower have the monthly cash flow to be able to afford the house? Banks will ask for verification of your income and permission to pull your credit report to verify this. Essentially, what they're looking for is debt to income ratio - they may calculate this slightly differently, but the idea is to add up your monthly costs related to debt (credit card payments, car loan payments, student loan payments, etc) and compare it to your monthly income. Banks will have a target for this value that determines the maximum they will be able to lend to you - if you want a $500k house but this formula says you can afford a $300k house, you'll get turned down.
- Is this borrower a big risk of defaulting on the loan? You'd think that cash flow would imply risk, but the importance of debt to income ratio on determining risk is unimportant below a certain value (which is how banks determine the value they use in the above bullet). In other words, other things equal, really rich people aren't inherently more or less likely to default as normally rich people. So, banks use your credit score as a factor to determine default risk. This is important for your question because risk determines rate. Banks do have floors on who they'll loan to, but assuming you're above that floor, your credit score plays a major role in determining the interest rate you'll pay.
That last bullet is where your question comes into play. Simply put, a better credit score will have a better interest rate. The difference can be significant, in the long run - a person with a 650 score may pay tens of thousands more in interest than someone with a 750 score, on an expensive house. So, of course, you want to get your score up before you apply for the loan, and you want to keep it up during the process of completing the transaction (since a bank will typically check your score at the time of your application, and again at the time of closing). All that said, you want to make sure you're not doing things that will influence the other factors banks are looking at - there's no use in doing something to improve your score if it indirectly means your DTI drops too much, for example. And, you need to be sure you understand how scoring works, because actions that improve one person's score may not work for other people.
The advice to take out an installment loan, and pay it back, is based on a few credit score factors:
- Having a credit history, full stop, obviously plays a big role in your score. If you have no history, or very little history, then using credit (of any kind) will likely make a positive impact to your score, assuming you use the credit responsibly.
- Credit mix - the ratio of revolving credit (like a credit card) to installment credit plays a small role in your score. If all you have right now is a few credit cards, then getting another type of credit will improve your score.
However, there's the chance for things to work out the other way:
- Taking out that installment loan will mean that the lending bank is going to do a hard pull on your score. That will drop it several points. This drop will likely last through the timeframe in which you're hoping to get a mortgage.
- Taking out a brand new loan (of any kind) will drop your average age of credit. This is a minor factor too, but can be significant. If all you have right now is a credit card that you've had for 3 years, and you take out a brand new loan, your average age is now 1.5 years, which will hurt your score. Depending on what your average age is, this impact can take a long time (many years) to recover from.
- Taking out that new loan will mean that, while it is active, your DTI will be worse. This doesn't impact your credit score directly (credit scores don't include any income-based factors) but it can impact the dollar amount you'll be approved for - some mortgage underwriting processes will include any debt within a certain timeframe - not just any currently active debt. So even if you've paid off a personal loan prior to applying for the mortgage, the bank may consider it in the decision process.
At this point, it should hopefully be clear that we can't give you a literal, direct answer to your question, since it'll depend on factors we don't know about you and your finances. If you're serious about optimizing your chance at getting a good mortgage, it probably makes sense to go talk to your credit union now versus waiting until you're ready to buy. Most credit unions will be happy to coach you on their process which will let you make the best decisions as you're looking at your finances and preparing to buy a home.
As a footnote, it's worth noting that for the purpose of determining interest rates, credit scores are divided into "paper grades" which are then priced. For instance, a bank may consider any score over 760 an A+, and 720 - 760 as A, 680 - 720 as B, and so on. Then, All A+'s get rate X, A's get rate Y, and so on. So - your exact credit score doesn't really matter, it just matters which grade you end up in. And, since you mentioned that you're around 740 now, it's worth mentioning that this may already be in, or very close to, your credit union's highest grade. Which would make this whole question moot, since as long as you're in the highest grade, improving your score further makes zero difference.
As another footnote, if you're trying to reduce the total cost you're paying for the mortgage, it's worth asking your credit union about PMI requirements and other features on their mortgages. For all intents and purposes, from a consumer's perspective, having a certain PMI requirement is basically like having your interest rate slightly higher. So, again, if you're trying to manage your finances over the next year with the goal of reducing your mortgage cost, make sure you understand any PMI you'll be required to carry. Underwriters generally require PMI based on the loan to value ratio (essentially, how big your downpayment is) and your credit score (people with a lower score may be required to carry a costlier policy).
And as a final footnote - there's almost always a human decision factor in a FI's underwriting decision for a mortgage. And as mhoran_psprep pointed out, that "sniff test" will likely result in the mortgage agent asking you to explain why you took out the loan. Basically, they're looking for unusual circumstances or signs that your finances may not be as stable as your hard numbers show. This can take other forms, too (for instance, if your proof of cash for the downpayment involves showing them your savings account bank statement, and the statement shows a sudden and large deposit the day before they ask for it, they're going to want to know where that money came from.) There's no formula for optimizing these questions, you just want to make sure everything is explainable and nothing is out of line.
