Can you purchase a home with student loan debt?
Getting a mortgage approval is possible if you manage your credit score properly, balance paying down debt versus saving for a down payment, and can keep your debt-to-income ratio within guideline limits.
Having student loans makes it more difficult to shine in each of these three main home-lending criteria.
However, it is not impossible. Learn how to strike the right balance and buy that starter house of your dreams.
How Student Loans Affect Mortgage Credit Scores
Student loan debt affects mortgage credit scores. Home lenders use credit scores as one tool to make an underwriting (approval or decline) decision. In addition, they rely heavily on these equations determine the interest rate to charge.
Mortgage overlay credit scores are slightly different from the generic FICO ® or Vantage scores, which predict future behavior on all account types. However, the primary factors remain the same.
- Payment history: 35%
- Amounts owed: 30%
- Length of history: 15%
- The diversity of accounts: 15%
- New account activity: 10%
Student loans have a big impact on the payment history component of your mortgage credit score. Payment history is the most important factor in determining your number.
- On-time payment builds a positive record and helps qualifications
- Minor delinquencies have a dampening effect
- Default is the most severe derogatory mark on a consumer report
- Deferral status is neutral on credit scores
Student loans also have a big impact on the amount owed element of your mortgage credit score. The amount owed is the second most important factor in determining your number.
Massive amounts of debt ($100K or more) will push down your score and make it more difficult to qualify for approval or the lowest interest rate. However, hope is not lost. You can still perform well on the other four factors and wind up with a decent rating.
Pay Off Student Loans or Save for House
Is it better to pay off student loan debt or save money for a house deposit instead? The answer depends on a number of variables. Saving for a deposit makes sense when a couple is close to a tipping point. On the other hand, paying down debt is best when you can lower monthly installments.
Save Down Payment
Saving for a larger down payment is better than paying off student loans when a couple is close to one of several tipping points. Your ability to qualify for a mortgage approval or pay lower interest rates improves once your deposit savings reach certain percentage thresholds.
- 5% FHA loan for good credit scores
- 10% FHA loan for poor credit scores
- 20% for conventional mortgages
Reaching the 20% down payment target for conventional mortgages means that you do not have to pay expensive private mortgage insurance (PMI). PMI allows individuals to finance a home purchase with a loan-to-value ratio (LTV) above 80%.
PMI rates range from .5% to 1% annually applied against the original principal amount. This figure factors into your front-end debt-to-income ratio (see below). Therefore, avoiding PMI improves qualifications.
Pay Off Debt
Paying down student loan debt is better than saving for a home down payment when you can lower your total monthly payment. Lower monthly payments improve your back-end debt-to-income ratio (see below). Fortunately, there is an easy way to make this happen.
A graduate with a bachelor’s degree can have up to 16 student loans.
- 1 federal loan per semester equals 8
- 1 private loan per semester equals 8
Pay off the smallest student loan entirely before buying a house. Instead of making equal payments on all 16 possible loans, pay extra on the one with the smallest balance until it is gone. Your total monthly payment drops immediately after you retire each obligation.
Student Loans Part of Debt-to-Income Ratio
Are student loans included in the debt-to-income ratio (DTI) on home loans? Mortgage companies calculate two sets of DTI ratios to determine whether you can afford to make all payments on time and according to terms.
- Front-end DTI 2018 limit: 31%
- Back-end DTI 2018 limit: 43%
Front End DTI
Student loans can impact the front-end debt-to-income ratio indirectly. Mortgage lenders calculate the front-end DTI by dividing your monthly income into several obligations relating only to your house.
- Homeowner insurance
- Real estate taxes
- Principal and interest
- Interest rate
As we saw earlier, credit scores affect interest rates and the size of your down payment determines PMI. In addition, a larger deposit lowers the principal amount borrowed.
Back End DTI
Student loans count towards the back-end debt-to-income ratio. Mortgage lenders calculate the back-end DTI by dividing your monthly income into all of your monthly obligations.
Government-sponsored enterprises (GSE) and/or agencies publish guidelines for how to calculate the DTI for student loans in deferment, forbearance, or under an income-based repayment plan.
- Federal Housing Authority (FHA)
- United States Department of Agriculture (USDA)
- Federal National Mortgage Association (FNMA or Fannie Mae)
- Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac)
Deferment or Forbearance
Student loans in deferment or forbearance count towards your back-end DTI in accordance with published guidelines. Remember that in order to qualify you must demonstrate a need – most commonly a temporary drop in income associated with college enrollment, unemployment, or economic hardship.
Most home lenders assign 1% of the outstanding balance each month or the projected monthly payment. These guidelines for student loans in deferment or forbearance apply with most agencies with some minor variations.
Student loans in income-based repayment (IBR) plans also count towards your back-end DTI. The published guidelines do allow for $0 monthly IBR payments. However, you may find yourself in trouble when the arrangements change.
The Department of Education requires that you recertify your annual income and family size each year. Therefore, your monthly installment obligation may fluctuate over time. Leave yourself with ample cushion for any of these options.
- Revised Pay As You Earn Repayment Plan (REPAYE Plan)
- Pay As You Earn Repayment Plan (PAYE Plan)
- Income-Based Repayment Plan (IBR Plan)
- Income-Contingent Repayment Plan (ICR Plan)