How to Get a Mortgage When You Have Student Loan Debt
Nearly 44 million Americans harbor student loan debt in excess of $1 trillion. For many people, student loans are key to getting the education they need to achieve their career goals. As helpful as that can be, most people know that going into debt to pay for college also has its downsides.
Student loans have a variety of repayment options, many of which can last more than 20 years. These monthly payments have an impact on your cost of living, but also on your credit. Student loans impact whether or not you can obtain a credit card, buy a car or qualify for a home loan mortgage.
Student loan debt is just one of many factors that impacts your eligibility for a mortgage. If student loans are the main chunk of your debt, you may be surprised to learn how substantially they can affect your home-buying process. If you have student loan debt and are considering buying a home, this guide walks you through two main elements you need to know: understanding your student loan repayment plan and getting an idea of your debt-to-income ratio. Once you know where you are in your loan repayment, you can work on getting your debt-to-income ratio to a percentage that will make your lender happy.
Student Loan Repayment Plans
Repayment plans can make paying down your student loans more affordable by giving you longer terms or rates based on your income. When you have an idea of how much you'll be paying each month — along with how many years it will take to pay it off — you'll have a baseline for the type of monthly mortgage payment you can afford. Repayment plans for student loans are typically categorized as:
- Standard: A fixed rate that ensures payoff in 10 years
- Graduated: Payments are lower at first, then increase every two years for a 10-year payoff
- Extended: Fixed or graduated payments for a 25-year term
- Pay-as-You-Earn: Payments are 10 percent of discretionary income
- Income-Based: 10 to 15 percent of discretionary income
- Income Contingent: Payments are lower than 20 percent of discretionary income
- Income-Sensitive: Your monthly payment is based on your income, but your loan will be paid off in 15 years
Before you find out what kind of mortgage you qualify for, it's important understand how your student loan debt will impact your finances. Once you understand how much you'll be paying and for how long, then you have a clear picture of the kind of house you can afford and the kind of loan your lender will be more likely to offer. Your lender will be interested in calculating and analyzing your debt-to-income ratio to determine the loan amount you can afford. Student loans play a large role in calculating this ratio.
Debt-to-Income (DTI) Ratio
A lender, the entity that provides the mortgage loan for the home you want to purchase, will calculate your loan eligibility based on many things, but the most important factor is your debt-to-income ratio. There are two main elements to a debt-to-income ratio: front-end ratio and back-end ratio.
Front End Ratio
A front-end ratio is essentially the ratio between your projected monthly mortgage payments and your gross monthly income. The lender will get an idea of this ratio by dividing the anticipated monthly mortgage payment, which will include the principal, taxes, insurance and interest (PITI), by how much you make before taxes.
Let's look at an example calculating a front-end ratio. Your annual salary is $50,000, which comes out to be $4,166 each month before taxes. Your PITI is $1,200 per month. To calculate this ratio, you would divide $1,200 by $4,166. That comes out to 0.28, or a front-end ratio of 28 percent. Most lenders will set the terms of the loan limit between 28 and 36 percent for the front-end ratio.
Back End Ratio
While the front-end ratio looks at the cost of the home and your gross monthly income, the back-end ratio considers all of your debt in comparison to your earnings. The lender will calculate this by compiling all of your monthly debt payments and then dividing that number by your gross monthly income. This is where your student loan debt can have a big impact on the amount of a mortgage loan you qualify for.
Let's look at an example of how to calculate a back-end ratio. Your annual salary is $50,000, or $4,166 per month. We will use the same PITI, $1,200 per month. You have a small balance on one credit card with a $50 minimum monthly payment. You pay $375 each month on your student loan. So, if all of your monthly debt payments come to $1,625, your back-end debt-to-income ratio is 39 percent. Most lenders will want that number under 36 percent. Some exceptions include:
- An FHA loan, which is insured by the Federal Housing Administration & offers a back-end ratio of 41 percent.
- A back-end ratio of 50 percent for people with excellent credit.
- A professional's mortgage for people just finishing graduate school with advanced degrees.
How to Improve Your DTI Ratios
So, how can you get your back-end ratio within the optimal range? First, consider paying off the smallest loans as quickly as possible. If you have two or three credit cards with balances under $1,000, you might be surprised at how big of an impact paying those off can make on your back-end ratio. Next, talk to your lender for your car loan to see if you can lower your monthly payments. Then, you can look at your student loan repayment plan to see if you qualify for a different one that offers lower monthly payments.
Remember, your back-end debt-to-income ratio takes a look at your monthly debt payments, so do what you can to lower those numbers. If you can't lower your monthly debt payments, you can also impact your back-end ratio by:
- Looking for a house that costs less and has a lower PITI.
- Making sure to have a 20 percent down payment.
- Focusing on boosting your income and earnings.
- Making life changes that can help raise your credit score, like paying off debt and negotiating a lower annual percentage rate (APR) on your credit cards.
Considering Alternative Home Loan Options
It is easier to move into a smaller home than it is to quickly increase your income. But if you have a certain home you really want to buy, some mortgage options offer a higher DTI ratio limit than traditional conforming mortgages allow for.
- VA and FHA loans have less stringent qualification requirements.
- Fannie Mae's HomeReady & Freddie Mac's Home Possible programs allow higher loan to value (LTV) and DTI limits.
|Mortgage Program||LTV||Back End Ratio|
|VA (for military veterans)||100%||41%*|
|USDA (rural areas)||100%||41%|
|Fannie Mae HomeReady||97%||43%|
|Freddie Mac Home Possible||95%||45%|
|Freddie Mac Home Possilbe Advantage||97%**||43%|
* benchmark, can vary from lender to lender
** up to 105% with an Affordable Second which is not a HELOC
While the above listed back end ratios were in Fannie Mae & Freddie Mac marketing materials, they do in some cases package loans with a back end ratio as high as 50%.
According to CoreLogic about 20% of conventional mortgages made this winter "went to borrowers spending more than 45% of their monthly incomes on their mortgage payment and other debts, the highest proportion since the housing crisis."
More Exotic Solutions
Some home manufacturers like Lennar Corp. are trying to entice buyers with student loan debt to buy homes by promising to pay off up to $13,000 of their student loans.
Loftium offers prospective buyers up to $50,000 for a down payment so long as the home buyer lists a bedroom from the property on Airbnb for 1 to 3 years & shares the rental income with their company. The down payment boost could in turn lower the mortgage debt enough to significantly improve the DTI ratio.
Getting Ready for Homeownership
Simply having student loans won't inhibit your chances of being approved for a mortgage; it's how they factor into your debt-to-income ratio that makes the difference. That's why it's so important to have a handle on all of your debt when you start looking into a home mortgage.
While all of these regulations may be inconvenient at times, the rules are there to make sure you don't get involved in a purchase that could lead to financial ruin. Getting stuck with a payment that you can't afford will not only damage your credit, but can also lead to stress and anxiety. You might feel frustrated if your student loans tipped your back-end ratio over 36 percent, preventing you from being qualified for a mortgage. Be patient and work at chipping away at your debt, keeping in mind that you can accomplish your home-owning goal when the time is right.
It may mean taking a few more years to restore your credit, build your down payment, and pay down student loans and other debts to help you qualify for the interest rate or a loan amount you want. Be sure to take the time to ensure the leap you're making into homeownership isn't a plunge into the deep end.