Buying a Home with Student Loan Debt
Jeff SeehorschJuly 10, 2019
Student loan debt soared beyond 1.5 trillion in the U.S. last year according to the Federal Reserve. The only form of debt that’s higher? Mortgage debt.
It’s no wonder why many Americans are delaying their purchase of a new home, either because of difficulties getting a home loan or doubts about being able to cover student loans and a mortgage at the same time. The good news is that by focusing on the right aspects of your finances now, you can both manage your student loan debt and become a homeowner sooner than you think.
Your Credit Score
If you’ve ever taken out a loan, opened a bank account or received a credit card in your name, you have a credit score. This is a three-digit number that reflects your payment history and how many accounts you have in good standing.
There are three primary credit bureaus – Equifax, Experian and TransUnion – that create individual credit reports. From there, a credit scoring model (like FICO®) assigns each person a number, usually between 300 and 850.
A bank or lender will look at your score to determine the mortgage and interest rate you qualify for. The higher your score, the less you should pay for a home loan.
How a Student Loan Affects Your Credit Score
Whether you have $1,000 or $100,000 in student loan debt, your balance should not affect your credit score. What will affect your score is making (or not making) monthly payments on time.
In this way, a student loan is no different from a car loan or a home loan.
How to Improve Your Credit Score
Of the many home buying dos and don’ts, building up your credit score is one of the most doable actions you can take. You can make positive gains regardless of how high your student loan balance is, and this can help you unlock the best mortgage options. Shoot for a credit score of 760 or higher to get the lowest interest rate possible.
Here are a few tips to raise your score:
- Make timely payments. A lot goes into a credit score, but one-time payments are the most important factor. The surest way to build your credit is by making monthly payments on time for all your accounts: car loan, rent, mortgage, cell phone, credit cards and, of course, student loans.
- Expand your credit limit. Most experts agree it’s best to keep your credit utilization ratio below 30%. Say you only have one credit card with a $5,000 limit, and you charge $2,000 per month. That means your credit utilization ratio is 40%. If you raise your limit to $10,000 and spend the same amount, your ratio drops to 20%. That’s good news for your credit score. To raise your credit limit, just raise the limits of your current cards or open a new one.
- Split monthly payments. Not all credit card companies report your balance at the same time. That means your credit utilization ratio could be considered higher or lower depending on when you make monthly payments. One way to prevent charges from building up – and weighing your credit score down – is to split your monthly payment. By making two payments a couple weeks apart, you can improve your chances of a lower ratio being reported.
Your Debt-To-Income Ratio (DTI)
In the eyes of banks and lenders, your debt-to-income ratio is another crucial aspect of your ability to repay a loan. In this case, the lower your ratio, the better home loan terms you can lock in.
To calculate your DTI, divide your total recurring monthly debt by your gross monthly income. Say you’re paying $300 for your student loan, $250 for a car lease, $50 for your cell phone and $200 for your credit card. That’s $800 per month in debt payments. Now say your monthly income is $2,000 per month. Divide the $800 by $2,000 and you get your DTI, which is 40%.
In most cases, your DTI will need to be under 43% to get a qualified mortgage that meets Federal government standards. Most lenders prefer to see a DTI below 36%, as this gives you much more wiggle room to cover your mortgage payments.
How a Student Loan Affects Your DTI
Just like any debt, student loans are factored into DTI, and it’s one reason why many non-homeowners are delaying buying a home. According to a report by the National Association of Realtors, over half of participants surveyed said that they couldn’t qualify for a mortgage due to their DTI. The good news is you can take steps lower your ratio, and the federal government has introduced some policies to lend a hand.
How to Lower Your DTI
Generally speaking, you either need to lower your debt or raise your income to improve your DTI. That usually means creating a strict budget, scaling back spending and/or picking up a side-gig to earn some extra cash.
Another option is consolidating your debt. If you’re making payments on several credit cards, consolidating those balances onto one credit card means you could lower how much you need to pay per month. If you’d rather pay off some of your cards instead of consolidating, don’t close your cards after your balance hits zero! Keeping your cards active will help boost your credit score.
Lastly, Fannie Mae created some policies in 2017 to help out people who are struggling to buy a home because of student loan debt. The following policies can potentially give you some more financial breathing room or provide more mortgage options to help you become a homeowner.
· Student Loan Cash-Out Refinance: Offers homeowners the flexibility to pay off high interest rate student debt while potentially refinancing to a lower mortgage interest rate.
· Debt Paid by Others: Widens borrower eligibility to qualify for a home loan by excluding from the borrower’s debt-to-income ratio non-mortgage debt, such as credit cards, auto loans, and student loans, paid by someone else.
· Student Debt Payment Calculation: Makes it more likely for borrowers with student debt to qualify for a loan by allowing lenders to accept student loan payment information on credit reports.
Your Savings for a Down Payment
A down payment is how much you pay out of pocket to buy a home. It shows bankers, lenders and home sellers that you’re a serious buyer. By paying more upfront, you can earn better mortgage terms and increase your chances of getting a purchase offer accepted.
Most conventional loans that offer the best rates will require you to put down 20 percent of a home’s sales price. Put down less, and you’ll have to chip in private homeowner’s insurance. But don’t feel like 20 percent is a must. Most first-time homeowners put down far less, and you can put down as little as three percent if you have strong credit.
The Student Loan Affect
It’s tougher to save for a down payment when you’re funneling a few hundred dollars toward student loan debt every month. For many Americans, it can seem like an either/or proposition: either pay down debt or save for a home.
If money is tight, that could signal it’s a good idea to pay down your highest-interest debt first to save more in the long run. Many student loans have variable interest rates, which go up over time and cost more down the road. In a situation where your DTI and interest rates are high, it might make sense to whittle down your debt until you’re paying less and/or generating more income each month.
With that said, there are financial benefits that come with homeownership that could make it worth your while to save for a down payment while you pay down debt. For one thing, owning a home can be less expensive than renting. The sooner you have enough money for a down payment, the less money you’ll sacrifice by living in an apartment. Plus, owning a home allows you to build equity. In time, you can refinance your home loan to put that equity toward your student loans.
Check out a few tips to save for a down payment while you pay down your student loans below.
How to Save More While Paying Down Student Loan Debt
One way you can ease some of the burden of student loans is by refinancing them. If you’re paying high interest rates (over 5%), you may be able to sell your loan to a private lender that offers rates as low as 2.5%. Private lenders typically have requirements that must be met, usually to do with your income, credit score and DTI. Refinancing can lower how much you spend long term, as well as your monthly payments, allowing you to put more toward a down payment.
If you’re unable to refinance your loans, target the highest-interest debt loans first, rather than let autopayments spread your wealth around. Pay the minimum for the lowest-interest loans. From there, take a hard look at your spending habits and cut every expense you can: eating out, clothes, vacationing, etc. You may even consider moving back in with your parents if you’re paying a big chunk of your income toward rent.
Create a separate high-yield savings account exclusively for your down payment, then stick to depositing as much as you can. Before you know it, you’ll be well on your way to homeownership!
Take Control of Your Home Buying Goals
There’s no two ways about it: student loans are a drag. But if you’re chipping away bit by bit, take comfort in the fact that millions of other people are in the same boat as you and new channels are opening up to make homeownership a realistic goal. There’s plenty of steps you can take to prepare financially. By focusing on what you can control and exploring all your options, you can overcome student loan debt and buy your first home with confidence.