The cost of a college degree isn’t getting any cheaper. The average American student owes more than $33,000, easily exceeding the average first salary most can expect, while an additional 15 percent of grad students finish with debts rolling into six figures.
Some might say college debt is a fair trade off in the long run, considering how a college graduate earns about a million more over his lifetime than someone with only a high school degree. While a college education can open the door to better jobs and income, student debt can throw a wrench in your home buying plans.
Many young homebuyers know the importance of steady income and good credit. Yet, some don’t fully grasp how student loans and other debts impact a home loan. They may apply for a mortgage with confidence, but have a rude awakening when the lender says they qualify for less than what they need.
Understanding debt limits
Mortgage lenders don’t only look at credit, work history and income—they also evaluate a borrower’s debt-to-income ratio. Debt plays a big role in affordability. Debt-to-income ratio is the percentage of your gross monthly income that goes to debt payments. Banks use a front-end and a back-end ratio to determine how much you can reasonably afford to spend on a house.
According to the front-end ratio, your house payment cannot exceed 28 percent to 31 percent of your gross income. The back-end ratio factors in all your debt payments (including the mortgage). Your total debt payments cannot exceed 36 percent to 45 percent of your gross income, depending on the type of mortgage loan.
The more debt you have, the harder it’ll be to realize your dream of homeownership. So even if you made responsible choices throughout college and didn’t accumulate a lot of credit card debt, a massive student loan payment can be the kiss of death when applying for financing.
“You are viewed as a risky borrower when applying for either an FHA, USDA or a conventional loan if you owe a large amount of student loan debt,” says Harrine Freeman, financial expert and author of How to Get Out of Debt: Get an A Credit Rating for Free. “You may be charged a higher interest rate or be approved for a smaller loan amount than desired.”
Student loans are installment loans and considered a type of “good debt.” Therefore, student loan balances don’t hurt your credit score as much as high balances on a revolving credit line, such as a credit card. However, debt is debt. And just like other types of debt, student loans can reduce purchasing power.
To illustrate, let’s say you earn $4,000 a month and you have $7,000 for a down payment. If you were to apply for a mortgage with good credit and zero debt, you can afford to spend about $189,938 for a house. But if you add a $300 student loan payment, your affordability drops to $137,479.
How student loan deferment affects a mortgage
Student debt can also affect a home purchase when loans are in deferment. Although a deferment lets you temporarily pause federal student loan repayment, lenders will factor in a percentage of your loan balance when calculating mortgage affordability.
Heather McRae, a senior loan officer with Chicago Financial Services in Chicago, IL, recently worked with a borrower who had to postpone a home purchase until she consolidated her student loans. The borrower earned about $3,500 a month, but owed more than $200,000 in student loans.
“Most of them are deferred right now,'” she says, “but I am required to count 1 percent of the loan balance against her when there is no available payment because the loan is deferred.”
The borrower was advised to consolidate all her federal loans into one loan, where she could receive a lower monthly payment based on her income. “Once she has the new payment, which she expects will be in 90 days and around $500, she will be able to buy,” says McRae.
What are your options?
So, what can you do if you’re ready to buy a house, but burdened with student loans? Hopefully, you won’t resort to any extreme methods (such as giving up an organ) to getting rid of your student debt. You can take McRae’s advice and consolidate your loans to receive a lower rate and monthly payment. This decreases your monthly expenses and increases how much house you can afford.
Can you hold off buying for a few years and live with your parents (or a roommate) while working full-time? You can save up and pay down your student loans, thus lowering your debt-to-income ratio. If you want to buy sooner rather than later, consider an FHA mortgage, which allows a higher back-end ratio.
Remember, this is only your first house. A student loan may limit how much you’re able to spend on a house, but at least you’re getting your foot in the door and building equity. As your income increases and your student loan balance decreases, it’ll be easier to qualify for a large mortgage down the road.