Buying a House When You Have Student Loan Debt
In the past, mortgage lenders were able to give people with student loans a bit of a break by disregarding the monthly payment from a student loan if that loan was to be deferred for at least one year after closing on the home purchase. But that all changed in 2015 when the Federal Housing Authority, Fannie Mae, and Freddie Mac began requiring lenders to factor student debt payments into the equation, regardless of whether the loans were in forbearance or deferment. Today by law, mortgage lenders across the country must consider a prospective homebuyer’s student loan obligations when calculating their ability to repay their mortgage.
The reason for the regulation change is simple: with a $1.3 million student loan crisis on our hands, there is concern homebuyers with student loans will have trouble making either their mortgage payments, student loan payments, or both once the student loans become due.
So, how are student loans factored into a homebuyer’s mortgage application?
Anytime you apply for a mortgage loan, the lender must calculate your all-important debt-to-income ratio. This is the ratio of your total monthly debt payments versus your total monthly income.
In most cases, mortgage lenders now must include 1% of your total student loan balance reflected on the applicant’s credit report as part of your monthly debt obligation.
Here is an example:
Let’s say you have outstanding student loans totaling $40,000.
The lender will take 1% of that total to calculate your estimated monthly student loan payment. In this case, that number would be $400.
That $400 loan payment has to be included as part of the mortgage applicant’s monthly debt expenses, even if the loan is deferred or in forbearance.
Are Student Loans a Mortgage Deal Breaker? Not Always.
If you are applying for a “conventional” mortgage, you must meet the lending standards published by Fannie Mae or Freddie Mac. What Fannie and Freddie say goes because these are the two government-backed companies that make it possible for thousands of banks and mortgage lenders to offer home financing.
In order for these banks and mortgage lenders to get their hands on Fannie and Freddie funding for their mortgage loans, they have to adhere to Fannie and Freddie’s rules when it comes to vetting mortgage loan applicants. And that means making sure borrowers have a reasonable ability to repay the loans that they are offered.
To find out how much borrowers can afford, Fannie and Freddie require that a borrower’s monthly housing expenses (that includes the new mortgage, property taxes, and any applicable mortgage insurance) to be no more than 43% of their gross monthly income.
On top of that, they will also look at other debt reported on your credit report, such as credit cards, car loans, and, yes, those student loans. You cannot go over 49% of your gross income once you factor in all of your monthly debt obligations.
For example, if you earn $5,000 per month, your monthly housing expense cannot go above $2,150 per month (that’s 43% of $5,000). And your total monthly expenses can’t go above $2,450/month (that’s 49% of $5,000). Let’s put together a hypothetical scenario:
Monthly gross income = $5,000/month
Estimated housing expenses: $2,150
Monthly student loan payment: $400
Monthly credit card payments: $200
Monthly car payment: $200
Total monthly housing expenses = $2,150
$2,150/$5,000 = 43%
Total monthly housing expenses AND debt payments = $2,950
$2,950/$5,000 = 59%
So what do you think? Does this applicant appear to qualify for that mortgage?
At first glance, yes! The housing expense is at or below the 43% limit, right?
However, once you factor in the rest of this person’s debt obligations, it jumps to 59% of the income — way above the threshold. And these other monthly obligations are not beyond the norm of a typical household.
What Can I Do to Qualify for a Mortgage Loan If I Have Student Debt?
So what can this person do to qualify? If they want to get that $325,000 mortgage, the key will be lowering their monthly debt obligations by at least $500. That would put them under the 49% debt-to-income threshold they would need to qualify. But that’s easier said than done.
Option 1: You can purchase a lower priced home.
This borrower could simply take the loan they can qualify for and find a home in their price range. In some higher priced real estate markets it may be simply impossible to find a home in a lower price range.
Option 2: Try to refinance your student loans to get a lower monthly payment.
Let’s say you have a federal student loan in which the balance is $30,000 at a rate of 7.5% assuming a 10-year payback. The total monthly payment would be $356 per month. What if you refinanced the same student loan, dropped the rate to 6%, and extended the term to 20 years? The new monthly payment would drop to $214.93 per month. That’s a $142 dollar per month savings.
You could potentially look at student loan refinance options that would allow you to reduce your loan rate or extend the repayment period. If you have a credit score over 740, the savings can be even higher because you may qualify for a lower rate refi loan. Companies like SoFi, Purefy, and LendKey offer some the best rates for student loans currently on the market. MagnifyMoney has a list of great student loan refi companies.
There are, of course, pros and cons when it comes to refinancing student loans. If you have federal loan debt and you refinance with a private lender, you’re losing all the federal repayment protections that come with federal student loans. On the other hand, your options to refinance to a lower rate by consolidating federal loans aren’t that great. Student debt consolidation loan rates are rarely much better, as they are simply an average of your existing loan rates.
Option 3: Move aggressively to eliminate your credit card and auto loan debt.
To pay down credit debt, consider a balance transfer. Many credit card issuers offer 0% introductory balance transfers. This means they will charge you 0% interest for an advertised period of time (up to 18 months) on any balances you transfer from other credit cards. That buys you additional time to pay down your principal debt without interest accumulating the whole time and dragging you down.
Apply for one or two of these credit cards simultaneously. If approved for a balance transfer, transfer the balance of your highest rate card immediately. Then commit to paying it off. Make the minimum payments on the other cards in the meantime. Focus on paying off one credit card at a time. You will pay a fee of 3% in some cases on the total balance of the transfer. But the cost can be well worth it if the strategy is executed properly.
Third, if the car note is a finance and not a lease, there’s a mortgage lending “loophole” you can take advantage of. A mortgage lender is allowed to omit any installment loan that has less than 10 payments remaining. A car is an installment loan. So if your car loan has less than 10 payments left, the mortgage lender will remove these from your monthly obligations. In our hypothetical case above, that will give this applicant an additional $200 per month of purchasing power. Maybe you can reallocate the funds from the down payment and put it toward reducing the car note.
If the car is a lease, you can ask mom or dad to refinance the lease out of your name.
Option 4: Ask your parents to co-sign on your mortgage loan.
Some might not like this idea, but you can ask mom or dad to co-sign for you on the purchase of the house. But there are a few things you want to make sure of before moving forward with this scenario.
For one, do your parents intend to purchase their own home in the near future? If so, make sure you speak with a mortgage lender prior to moving forward with this idea to make sure they would still qualify for both home purchases. Another detail to keep in mind is that the only way to get your parents off the loan would be to refinance that mortgage. There will be costs associated with the refinance of a few thousand dollars, so budget accordingly.
With one or a combination of these theories there is no doubt you will be able to reduce the monthly expenses to be able to qualify for a mortgage and buy a home.
The best piece of advice when planning to buy a home is to start preparing for the process at least a year ahead of time. Fail to plan, plan to fail. Don’t be afraid to allow a mortgage lender to run your credit and do a thorough mortgage analysis.
The only way a mortgage lender can give you factual advice on what you need to do to qualify is to run your credit. Most applicants don’t want their credit run because they fear the inquiry will make their credit score drop. In many cases, the score does not drop at all. In fact, credit inquiries account for only 10% of your overall credit score.
In the unlikely event your credit score drops a few points, it’s a worthy exchange. You have a year to make those points go up. You also have a year to make the adjustments necessary to make your purchase process a smooth one. Do keep in mind that it is best to shop for mortgage lenders and perform credit inquiries within a week of each other.
You should also compare rates on the same day if at all possible. Mortgage rates are driven by the 10-year treasury note traded on Wall Street. It goes up and down with the markets, and we’ve all seen some pretty dramatic swings in the markets from time to time. The only way to make an “apples-to-apples” comparison is to compare rates from each lender on the same day. Always request an itemization of the fees to go along with the rate quote.