If you have student loans and want to own a home – whether in the next month, next year or next decade – you need to manage how your student loans affect your debt-to-income ratio and overall credit score to ensure you’ll be approved for a mortgage when the time comes. Here are the main things to keep in mind.
Your Debt-to-Income Ratio
A debt-to-income ratio is one way lenders measure your ability to manage and meet your monthly loan payments. If you’re applying for a mortgage, a lender will calculate your debt-to-income ratio by adding up all your monthly debt payments, including your expected mortgage amount, and dividing them by your gross monthly income – the amount you earn before taxes and other deductions.
Debt payments include mortgages, auto loans, student debt, credit card debt and any other installment or revolving debt. It does not include other budget expenses such as utilities. Some lenders may not approve you for a mortgage if your debt-to-income ratio exceeds 43 percent.
The Role of Your Student Loans
Let’s say you’re a recent college graduate earning $45,473 annually – the average for the college class of 2014. Your gross monthly income would be about $3,789. You have a car loan monthly payment of $200 and a credit card payment of another $200. On top of that, let's say you have $30,000 in student loans, about the average amount of debt for graduating college seniors. Assuming this is an unsubsidized Stafford loan at 4.6 percent interest, you may have a monthly payment of $312.
Now, let's say you’re applying for a home loan of $222,261 with a $1,061 monthly payment – the national average. Your total monthly debt payments would total $1,773 and your debt-to-income ratio would be around 46 percent, putting you over the 43 percent threshold and potentially out of luck for buying that particular house. Potentially.
Options to Manage Your Loans
While your car and credit card payments can’t be adjusted without refinancing the auto loan or paying down your credit card balance, any federal student loans have some flexibility. Using the example above, switching your student loan repayment plan from standard to graduated would result in a monthly payment of just $176. That reduces your debt-to-income ratio to 43 percent, potentially increasing your chances of being approved for the mortgage.
It’s important to recognize that the graduated plan assumes your salary will rise in the next few years. Your student loan payments start low with this plan but then accelerate. The last thing you want, is to take on a mortgage that you can’t afford if your student loan payments rise. If you don’t think your salary will increase anytime soon, you may want to check out some other repayment options like income-based plans.
Ways to Elevate Your Credit Score
Student loans can also affect your mortgage approval in that they are an important factor in your credit score. Paying your student loans on time each month is an excellent way to build good credit.
A lender will use your credit score to not only evaluate whether your mortgage should be approved, but also to determine your mortgage’s interest rate. Borrowers with higher scores are eligible for lower interest rates and more loan choices, while subprime borrowers face higher interest rates, less eligibility for different varieties of loans and possibly even denial of their mortgage request.
Federal student loans are usually reported to credit bureaus as delinquent after 60 days of no payment; private loans may be classified as delinquent – or even defaulted – after just one missed payment. If late student debt payments are dragging your credit score down, contact your student loan holder to talk about getting your payments back on track.
You can bring your account current by making all the payments you’ve missed, switching to a different payment plan or temporarily postponing payment and halting any more damage to your credit report. If you’ve defaulted on your student loan, you can rehabilitate your loan back to good standing and remove the default from your credit history – though the delinquency will stay.
If you are planning to take on more student loans and you want to buy a home soon after you leave college, stick to federal student loans and avoid private loans if possible. The flexibility to lower your monthly payments can be crucial to maintaining a healthy debt-to-income ratio and credit score.
Also keep in mind you can also have your student loan temporarily deferred for about one year. With the deferment, the lender will not factor the amount of the student loan into your debt to income ratio, making it possible for you to purchase more home, providing you can afford to make the payments without stress.