Buying a Home with Student Loans: What To Know & How To Buy
It’s funny, when you were a kid, you didn’t have a worry in the world.
Never once were you worried about the clothes you wore (thanks mom for the pants with the zipper at the knee), or about the music you listened to, and especially not about how much money you had in your wallet, or more like piggy bank.
And within a blink of an eye, you are all grown up. Now entering a new chapter of life with a new set of responsibilities, priorities and questions needed to be answered.
Almost guaranteed, many of us have asked ourselves: what do I want to be when I grow up?
You may have answered with an occupation, adjective or possibly the most common response with “I don’t know.”
But, you may have suspected you wanted to continue your education onward in college.
Who wouldn’t want to expand their knowledge and make a difference in the world?
Blink again and you are now done with the best four, maybe five years of your life and you are now thrown into the “adult world”. What happens next?
With college being a heavy expense, many students take out student loans. Most loans need to be repaid and follow a specific payment schedule.
Your major and career path will determine how much schooling will be required, which also determines the amount of student aid you will need.
College education is now more expensive than ever, which is forcing students to take out multiple loans to cover the expenses.
Now here’s the question: how long does it take to pay off all student loans?
To put in perspective, post-graduate students are delaying their home buying plans because of their student loans.
According to a recent study conducted by the American Student Assistance (ASA), 71 percent of student loan borrowers are delaying their home buying plans because of their student loans.
Which leads us to this – how does student debt affect mortgage?
Buyer’s top concern
As the Millennial generation is approaching the idea of obtaining a mortgage, there is one main factor that is holding them back; their student loans.
Americans are geared to continue their education past high school and onto college. However, the burden of student loans is making the want and need to heighten their knowledge a struggle.
To paint a picture, here’s a little breakdown on the latest report on student loans:
- In 2017, there is $1.44 trillion in total U.S. student loan debt
- There are 44.2 million Americans with student loan debt
- The average monthly student loan payment (for borrowers aged 20 to 30 years): $351
- The median monthly student loan payment (for borrowers aged 20 to 30 years): $203
And the daunting question remains: why is it so expensive to gain a higher education?
With the heavy responsibility paying off student loans, it is clear why buyers are hesitant on whether they are ready to finance a home.
The amount of debt all students accumulate to further their education is freighting. And unfortunately, there seems to be no signs of the expense slowing down.
How does student debt affect mortgage?
Not only does student debt create stress financially, but it also can complicate your mortgage process.
To apply for a mortgage, your lender will require specific information from you, like your employment history, income, W-2’s and any debts.
Yep, mortgage lenders pay special attention to the debt you already owe, whether it is for a student, car credit card or any other type of loan.
Student loans in particular, affect your mortgage loan application more so than other loans. Due to their balance size and long-term repayment schedules, your lender will analyze and judge your financial ability to afford a mortgage.
However, it is possible to get a mortgage loan while having student debt. Your lender will carefully look at your front-end and back-end debt-to-income ratio (DTI) to conclude the amount you can afford for a mortgage loan.
What is a front-end ratio?
A front-end ratio is also known as a housing ratio. This ratio can be calculated by dividing your projected monthly mortgage payments by your gross monthly income (your income before taxes).
A projected mortgage payment takes into account of your principal taxes, insurance and interest payments, collectively known as PITI.
For example, Ian earns $50,000 a year, which is about $4,166 per month.
Ian’s PITI comes to $1,200 per month.
To calculate the front-end ratio, divide the PITI by the gross monthly income: $1,200 / $4,166 = .28 percent.
In the end, your lender will set the term of the limit for conventional loans. This term can vary depending on your lender, but generally, you can expect ranges from 28 to 36 percent for front-end ratios.
What is a back-end ratio?
A back-end ratio looks at your debts and other current financial obligations. Your lender will calculate this ratio by adding your monthly debt payments and then dividing that number by your gross monthly income.
These debts can come from credit card payments, PITI on your mortgage, car loans and of course, student loans.
For example, Ian still earns $50,000 a year, so his monthly income is $4,166.
His PITI is still $1,200 per month.
Now, let’s add his debts. Ian has a credit card balance with a $50 per month minimum payment. Along with his student loan payment of $375 per month.
Ian’s total monthly debt payments include: PITI ($1,200) + credit card ($50) + student loans ($375) = $1,625.
To calculate the back-end ratio, divide the monthly debt payments by the gross monthly income: $1,625 / $4,166 = .39 percent.
Here’s the catch – usually, lenders like to see a back-end ratio under 36 percent for conventional loans. If you are taking out an FHA loan, the highest back-end ratio is 41 percent.
For Ian’s case, he could qualify for an FHA loan, but maybe not so much a conventional loan. This scenario demonstrates on how student loans or other debts can affect your ability to qualify for a mortgage loan.
What other factors should you consider?
There are a number of other factors you should consider before you take the plunge into homeownership. For example:
As a general rule of thumb, it’s best advised to save enough for a 20 percent down payment. The amount you put down will affect your front-end ratio, meaning, the more you borrow, the higher the projected mortgage payment. If you save enough for a 20 percent down payment, your student loans are unlikely to affect your mortgage loan process.
Amount of income
Your income is a huge deciding factor whether to accept you as a loan applicant. Your lender will look at your debt-to-income ratio (both front and back-end) to assess your debts and earnings. Although student loans create a large dent in your pocket, your lender may look beyond the total balance. Some lenders are more willing to accept applicants with student loans because they most likely have a bachelor’s degree or higher. Meaning, they have a higher income.
If you spent your early adult years in graduate school, you most likely have built up a few more thousand dollars of student debt. This won’t necessarily set you back, however, the lack of employment might. As part of the mortgage application process, your lender looks at your credit history. In addition to your employment history; most lenders want to see at least two years of employment history. Some lenders even require applicants to stay at the same company for two years to show consistency. If you have under two years, you may get denied from getting a loan.
Still interested in buying a home?
Yes, it is possible to obtain a mortgage while having student loan payments. However, you need to be comfortable with the idea of having two large debts over a long period of time.
Before taking on a new set of responsibilities, here are the top four things you must do if you are buying a home with student loans:
1. Improve your credit score
Without a doubt, the most important piece of information your lender will look at is your credit score. This determine whether or not they will accept you as a loan applicant. If you have student loans and you are paying them on time, you can maintain a good credit score.
If you are looking for ways to improve your credit score, there are four easy ways:
a. Pay your bills on time – Never miss a payment. Always pay your bills on time and in full. This way, you can build a solid and steady financial reputation.
b. Manage your credit utilization – Credit utilization is the ratio between your credit balances to your total available credit lines. Let’s say Ian has credit lines totaling in $3,000 and his credit balances total of $1,000. Divide Ian’s credit balances total by his credit lines: $1,000 / $3,000 = .30 percent. To manage your credit utilization well, it’s best to use no more than 30 percent of your available credit.
c. Don’t close old accounts – It seems logical to close an account that is old or not as active. However, this is not the best solution. Older bank accounts, especially in good financial standing, can help improve your credit score. This is because of its long credit history and maturity.
d. Use different types of credit – Lenders need to evaluate your credit history before they can approve you. If you have only one debt payment, it’s hard for lenders to judge whether or not you can handle a mortgage. Try using different types of credit, such as credit card payments or car loans. This will show your lender you can handle other types of debt.
2. Decrease your debt-to-income (DTI) ratio
As mentioned earlier, your lender will analyze your debt-to-income (DTI) ratio, which will help determine your ability to make monthly mortgage payments.
If you are buying a house with student loans, lenders will take this information into account.
Meaning, they follow a specific model called the 28/36 qualifying ratio to determine if you are eligible for the best rates.
Simply, this rule implies that you should spend no more than 28 percent of your gross monthly income on total housing expenses and no more than 36 percent on total debt service (including the new mortgage payment).
The most effective way to reduce your DTI is to increase your income. Either take a second job, get a side gig or ask for a raise.
Increasing your income will help pay off loans easier and add to your gross monthly total.
Depending on your financial status and loan situation, you may be able to refinance or consolidate your student loans to obtain a lower monthly payment.
If you choose to refinance or choose a new repayment plan, this could help improve your DTI.
3. Get pre-approved
Every mortgage process should start by getting pre-approved.
A pre-approval from a lender will help straighten out your finances and see what else is required from you.
During this process, your lender will observe your income, employment history, credit history and assets.
First and foremost, your lender will look at your financial history. All funds and transactions will need to be sourced and explained to your lender.
Especially any large deposits into your bank account that does not come from your income.
As a first-time homebuyer, it is not uncommon to receive a little financial help from your parents or a close family member. Or participate in a local homebuyer program.
These funds are called gifts, and these too need to be sourced and cite by a lender’s gift letter. If this financial help is intended to be used for a down payment, it needs to be sourced as a gift, not a loan.
When you are being pre-approved, your lender will require specific information and documents from you to accurately determine your eligibility.
Some basic documents include your W-2’s, two years of federal tax returns, 2 months’ work of bank statements and much more.
4. Consider financial assistance
Depending on what state and city you live in, there are several financial assistance programs people can take advantage of.
These programs are intended to help potential homebuyers with down payment assistance, refinancing and scholarships for loans.
In addition to these financial assistance programs, the type of loan you chose can help lower the costs of a mortgage.
For example, if you qualify for an FHA loan, your down payment can be little as 3.5%. A USDA loan on the other hand, requires no down payment, but these loans are granted for those who live in rural areas.
Wait it out
Sometimes, it’s worth the wait and put the homeownership dream on hold.
If it is difficult to manage and keep up with current payments or if your loans are in forbearance, it’s best to wait it out until you are financially ready to handle a mortgage.
You also have to be comfortable balancing two large debts over a long period of time. Your amount of income should help you confidently decide if you are ready to handle that type of financial responsibility.
In addition, you will need to prioritize and clearly sort out your goals.
Will this new debt set you back in other areas in your life?
Will you have to cut back on other expenses or contributions, such as your retirement plan?
Logically and realistically consider what your top priorities are and plan accordingly.
It may be frustrating to accept the fact your student loans are holding you back from financing a mortgage, but it could be worth the wait.
This can actually be a blessing in disguise.
If you delay your plans for a few more years and have paid off some of your student loans or other debts, this could help you qualify for a lower interest rate or a higher loan amount.
In addition, this extra time can help you build a better credit score and financially stabilize yourself so you can have the home of your dreams.