Buying a Home with Student Loans: Is It a Good Idea?
Before you find out whether or not you qualify for a mortgage (and how much you qualify for), you need to determine whether a mortgage is the right choice for you where you are now.
To find the answer to this question, you should look at your individual situation, and possibly even consult with a financial advisor. Ask yourself these questions if you’re thinking about getting a mortgage with student loans in tow:
- How are your student loans affecting your credit score?
- What is the current interest rate on your student loans?
- Can you handle a monthly mortgage payment on top of your current monthly budget minus rent?
Student Loans and Your Credit Score
Student loans can be a major pain, and they can slow down your life financially in many ways. However, student loans do have an upside: if you make every payment on time every time, they will have a positive effect on your credit.
On the other hand, late payments on your student loans will bring down your credit rather quickly. If this is the case, it may be in your best interest to wait to apply for a mortgage until you can improve your credit score.
Federal student loans for the 2017-2018 year ranged from 4.45% to 7% (StudentAid.ed.gov), and private student loans are typically even higher if you don’t have a pristine credit score. Before you determine whether you’re eligible for a mortgage, make sure you know the interest rate on your loan or loans. This is important because the higher your interest rate, the more reason you have to pay off your student loans before taking on new debt.
Budget, Budget, Budget
As with any major financial decision, one of the first steps in deciding whether or not you’re ready is creating a detailed, realistic budget. Your budget will change drastically when you own your own house, in more areas than just an added mortgage payment.
Make sure you consider house maintenance costs and utilities you may not be responsible for with your rental, as well as property taxes and possible HOA fees. Create a complete budget that outlines the costs you have now, as well as those you would face as a homeowner.
Debt-to-Income Ratio and Student Loan Debt
When you apply for a mortgage, your lender is going to look at your credit score, as well as your ability to make payments, based on their judgment. While you may feel ready to take on the responsibility of monthly mortgage payments, a lender might not see things the same way.
To determine whether you’re capable of making payments in full and on time, lenders look at your front-end and back-end DTI (debt-to-income) ratio. These numbers also determine how large a mortgage loan you can afford.
The back-end ratio is sometimes used in conjunction with the front-end ratio, but it is often used alone to determine whether a borrower is eligible for a mortgage. The back-end ratio is what is usually referred to as the DTI.
Your lender will find your back-end ratio by dividing your total monthly debt expenses by your gross monthly income (income before taxes) and multiplying that by 100.
|Example of Back-End DTI|
|Janie’s anticipated monthly housing expenses, which include her mortgage payment with interest, home insurance, and property taxes (PITI), are $1800.
Her other debt payments, including student loans and credit cards, total $800 per month, bringing her total monthly debt expenses to $2600.
Her gross monthly income is $7500. $2,600 (debt) divided by $7,500 (gross income) = 0.346 .
Therefore, Janie’s back-end ratio is 34.6%
Investopedia lists lenders’ ideal back-end ratio as anything under 32%, with a few exceptions for borrowers with good credit.
Student loan debt will have the biggest impact on your back-end ratio, which can prevent you from getting a mortgage from certain lenders. You can improve your back-end ratio by paying down your debts.
The front-end ratio is sometimes used in addition to the back-end ratio to determine whether a borrower is eligible for a mortgage. Having a higher front-end ratio can help counterbalance a low back-end ratio by showing lenders your ability to make payments.
To find your front-end ratio, a lender will add up your projected housing expenses and divide that by your gross monthly income. The lender will then multiply this number by 100.
|Example of Front-End DTI|
|Janie’s housing expenses, including mortgage payment with interest, home insurance, and property taxes (PITI) are $1800.
Her gross monthly income is $7500.
1800 divided by 7500 = 0.24
Therefore, Janie’s front-end ratio is 24%.
According to Investopedia, most lenders’ ideal front-end ratio for most loans is under 28%, or under 31% for FHA (Federal Housing Administration) loans, so Janie is in perfect standing to apply for a mortgage.
Your front-end ratio is important because it can help you get a mortgage if it’s high. On the other hand, even with an excellent credit score, a low front-end ratio could prevent you from getting a mortgage. However, you may be able to work around this obstacle by enlisting a cosigner with a high monthly income and a good credit score or by putting down a larger down payment.
DTI Ratio and Income-Based Repayment Plans
A statement made by Fannie Mae in 2017, ruled that the DTI of borrowers currently enrolled in an income-driven repayment plan should reflect the adjusted monthly payment under their plan, even if that payment is $0.
In other words, if you’re enrolled in an income-driven repayment plan or in a period of deferment on your student loans, your DTI should not include a student loan debt payment you’re not currently making.
Qualifying by Refinancing
If you need to lower your DTI to qualify for a mortgage, refinancing your loans could be a viable option. You may have the opportunity to extend your loan term by enrolling in a government program or to refinance with a private lender.
Consider the following refinance options:
- See if you’re eligible for income-driven repayment
- If you have good credit, look into refinancing with a private lender who can offer a lower interest rate and help you pay off your loans faster.
- Consolidate your federal and private loans (remember that by doing so, you’ll lose many federal benefits like forgiveness).
Finding the Best Mortgage with Student Debt
When you have a lot of student debt, you need to choose the best mortgage based on your situation. Luckily, there are mortgage programs designed specifically for buyers with student loan debt. The two main characteristics to look at when you’re shopping for a mortgage is whether it’s federally-backed or private, and the structure of the loan, including interest rates.
Government-Backed vs. Conventional Mortgages
The two main types of mortgages are conventional loans and government-backed loans.
Conventional loans are offered by private banking institutions and lenders, they aren’t backed by any outside body. With most conventional loans, you need to have a good credit score, and you’re expected to put down a payment of at least 5% upfront. Terms for a conventional mortgage are usually 10, 15, 20, or 30 years.
Government-backed loans come in three different forms:
FHA loans are the most common type of government-backed housing loan, and they allow for lower down-payments (as low as 3.5%).
These are insured by the Department of Veterans Affairs and offer low or no-down-payment options and competitive rates to service members and veterans only.
These are backed by the U.S. Department of Agriculture and apply to rural property buyers who meet certain requirements.
Interest Rate and Term
When you choose a mortgage, you’ll need to choose whether you want a fixed or adjustable rate. Fixed-rate mortgages offer an interest rate that never changes, which is best for borrowers who are fairly stabled and settled into their career. With this type of loan, you’ll know exactly how much interest you’ll pay for the full term of your loan. You can use our amortization calculator to see how much of your monthly payment goes towards principal vs interest, as well as how much interest you would pay on the loan in total.
On the other hand, adjustable-rate mortgages (ARMs) offer interest rates that reset. You will often be given what’s known as an introduction or “teaser” rate, which is lower, followed by an increased rate based on an index. These loans are better for borrowers who don’t plan to stay in the home for 10 to 30 years and want to pay a lower interest rate for the short time that they are there.
Getting a Mortgage with Student Loan Debt: Choose Wisely
Getting a mortgage is no small decision, especially when you’re already carrying significant student loan debt. However, student debt shouldn’t prevent you from pursuing your dream of owning a home, as long as you can truly afford it.
Make sure you know the ins and outs of any mortgage you’re considering before you move forward, and you’re aware of how that mortgage will affect your ability to pay down your student debt.