For many college graduates, the American Dream of owning a home seems blocked by a wall of student loan debt. But, home ownership is still possible, if you understand how student loans affect your debt-to-income ratio.
What is the Debt-to-Income Ratio?
The debt-to-income ratio is the percentage of your total monthly income that is devoted to making monthly payments on your debt.
Your ability to purchase a home depends on your debt-to-income ratios because lenders want to make sure you can afford both the student loan payments and a new mortgage payment.
The lower your debt-to-income ratio, the more you can qualify to borrow.
How to Improve your Debt-to-Income Ratio
There are several steps you can take to improve your debt-to-income ratio. These include reducing the amount of debt, changing student loan repayment plans, refinancing your student loans and increasing your income.
Reduce the Amount of Debt
Get rid of some of your monthly loan payments by paying off your debts. This can help you qualify for a mortgage by reducing your debt-to-income ratio.
- Pay off all consumer debt and avoid carrying a balance on your credit cards.
- If possible, pay off any auto loans or the balance due on larger lines of credit in order to eliminate another monthly payment.
- Do not apply for any new credit cards or loans for at least 6 months prior to buying a home.
- Do not cosign a loan. When you cosign a loan, the loan gets reported on your credit history as your debt, increasing your debt-to-income ratio.
Change Your Student Loan Repayment Plan
The debt-to-income ratio is based on the monthly loan payments, not the total amount of debt. Choosing a repayment plan with a lower monthly payment will help you qualify for a home loan by reducing the debt-to-income ratio.
There are several repayment plans that will provide a lower monthly student loan payment. These repayment plans reduce the monthly student loan payment by stretching out the term of the loan, which increases the total interest.
- Income-Driven Repayment. There are four income-driven repayment plans that base the monthly loan payment on your income and family size, as opposed to the amount you owe. Generally, Pay-As-You-Earn Repayment (PAYE) will yield the lowest monthly payment. If you do not qualify for PAYE, compare the Revised-Pay-As-You-Earn Repayment (REPAYE) and Income-Based Repayment (IBR). The loan payment under REPAYE is based on a smaller percentage of discretionary income than IBR, but counts your spouse’s income. IBR ignores your spouse’s income if you file separate federal income tax returns. Income-Contingent Repayment (ICR) has the highest monthly payment, because it is based on the largest percentage of discretionary income and the largest definition of discretionary income.
- Extended Repayment. Extended repayment has a fixed monthly payment, like standard repayment, but the monthly payment is smaller because extended repayment uses a longer repayment term.
Refinance Your Student Loans
Refinancing your student loans may reduce the monthly payment by reducing the interest rate.
However, refinancing does not save as much money as you might think. Cutting the interest rate in half does not cut the monthly payments in half, as most of the payment is devoted to repaying the principal balance of the loan, not the interest. Also, a lower fixed interest rate may require a shorter repayment term, which can increase the monthly payment.
For example, suppose you have a federal student loan of $30,000 at 6.8% with a 10-year repayment term. Cutting the interest rate in half, to 3.4%, reduces the monthly loan payment by 14 percent, from $345 to $295.
If you cosigned a loan, ask the borrower to refinance the loan entirely into their own name.
Increase Your Income
Another way to reduce your debt-to-income ratio is by increasing your income. Ask your employer for a raise or work a second job in the evening and weekends.
Don’t switch jobs for at least a year before you apply for a mortgage, even if the new job pays better, because mortgage lenders want borrowers who have stable employment.
Improve Your Credit Scores
The interest rate on a mortgage is based in part on your credit score. Getting a better credit score can lead to a lower interest rate. Borrowers with a very good or excellent credit score get the best interest rates. A lower interest rate on the mortgage will reduce the debt-to-income ratio associated with the home loan.
The best way to improve your credit score is to pay all your bills on time for an extended period of time. Demonstrating that you are a responsible borrower will help you qualify for a mortgage and get a lower interest rate on the mortgage.
Fannie Mae and Freddie Mac
Fannie Mae and Freddie Mac are secondary markets that provide liquidity to mortgage lenders by buying mortgages from them. These lenders must conform to the mortgage lending standards established by Fannie Mae and Freddie Mac.
Fannie Mae and Freddie Mac changed their guidelines in 2015 concerning how lenders must consider student loan payments when evaluating a borrower’s eligibility for a mortgage.
Both Fannie Mae and Freddie Mac require that housing expenses for borrowers be no more that 45% of their gross monthly income. (The threshold is 43% for Home Possible Advantage Mortgages.) In addition, the debt-to-income ratio cannot exceed 49% after factoring in all debt, including student loan payments.
The student loan payments are based on the figures reported in the borrower’s credit report. Sometimes the payment on the credit report is incorrect or the credit report shows a payment of $0. When this occurs, both Fannie Mae and Freddie Mac have new rules for how mortgage lenders may consider the borrower’s student loan repayment plans.
As of December 2018, Fannie Mae determines the qualifying monthly payment for a student loan using one of these options.
- If the borrower is on an income-driven repayment plan, the lender may obtain student loan documentation to verify that the actual monthly payment is $0. The lender may then qualify the borrower with a $0 payment.
- For deferred loans or loans in forbearance, the lender may calculate
- a payment equal to 1% of the outstanding student loan balance (even if this amount is lower than the actual fully-amortized payment), or
- a fully-amortized payment using the documented loan repayment terms
As of November 2018, Freddie Mac offers a more flexible option for considering student loan payments, regardless of whether the loans are in forbearance, deferment or repayment.
- If the monthly payment amount is greater than zero, use the monthly payment amount reported on the credit report or other file documentation, or
- If the monthly payment amount reported on the credit report is zero, use 0.5% of the outstanding balance, as reported on the credit report
Be Responsible with Home Financing
Before buying a home, consider a few options for ensuring that you can afford the mortgage payments despite the student loan debt.
Purchase a Less Expensive Home. Even if you qualify for a big mortgage, look at homes that are cheaper than this. If you borrow to the limit, you will be house rich and cash poor. Borrow less, so you have money to pay down your student loans quicker. Look for a smaller starter home, which will also require less upkeep.
Shop around for a Lower Mortgage Rate. Interest rates go up and down with the market and it is important that you compare mortgage rates from multiple lenders. Just because you have student loan debt, does not mean you should take the first offer.
Beware of paying points on a mortgage. Paying points is a way of buying down the interest rate on the mortgage. But points are a form of up-front interest that you lose if you refinance the mortgage or sell the home.
Is it worth it?
Buying a home when you have student debt is a long term financial undertaking. Make sure you are ready for it and understand your finances. You will need to be comfortable with owing two large debts – your mortgage and your student loans – that will be with you for a long period of time. This means maintaining a stable job and good credit scores should be at the forefront of your mind.
Consider your financial goals. Will buying a home stop you from saving for your child’s college education or your retirement? If you are struggling to repay your student loans, sometimes the last thing you need is to pile on more debt in the form of a mortgage.