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If you're a recent college grad and hope to become a homeowner in the near future, you should know that student loan debt could affect buying a home by making it more difficult to get a mortgage. Some 83% of non-homeowners say student loan debt is preventing them from buying a home, according to the National Association of Realtors (NAR).
But while student loan payments can make it harder to save for a down payment on a home, they shouldn't stop you from pursuing your dream of homeownership. The average first-time home buyer in 2018 had $30,000 in student loan debt, NAR reports. Keep reading to learn how you can manage student loan debt and still get approved for a mortgage.
How Student Loans Affect Getting a Mortgage
Having a student loan, in itself, isn't a deal breaker when it comes to getting a mortgage. What lenders care about is how debt you currently have (including your student loan debt) might affect your ability to repay the mortgage.
When you apply for a mortgage loan, your debt-to-income ratio (DTI) is one of the factors lenders consider. DTI compares the total amount of your recurring monthly debt with your total monthly income. To calculate your DTI, add up all of your recurring monthly debt (such as minimum credit card payments, car loan payments and, of course, student loan payments) and divide it by your gross monthly income (the amount you earn before taxes and other withholdings).
Suppose new grad Maria has a monthly income of $3,500 and a total recurring monthly debt of $1,200. Her DTI is 34% ($1,200 divided by $3,500). In general, lenders want to see a DTI of 43% or less before approving you for a loan, and many lenders prefer a DTI below 36%.
What happens if we add a monthly student loan payment of $393 to Maria's debt load? (This is the average student loan payment, according to the Federal Reserve.) Now Maria's recurring monthly debt is $1,593, increasing her DTI to 45%—too high to get a mortgage. More than half (52%) of non-homeowners in the NAR survey say their DTI is keeping them from qualifying for a mortgage.
Student Loan Impact on Credit Scores
Your credit score is a number that lenders use to assess your financial history and determine how creditworthy you are. It's based on several factors, including how much debt you have, what kind of debt you have and whether you pay your debts on time. (If you're not sure what your credit score is, get your free score from Experian to find out.) Most people have many credit scores, with variations depending on the model used. Lenders choose which to use when making their decisions, and typically use a FICO® Score* when evaluating mortgage applications.
Like all types of debt, student loan debt can affect your credit scores either positively or negatively. Missing a student loan payment or making a late payment will have a negative impact on your scores. Late payments remain on your credit report for seven years.
Making student loan payments on time every month, on the other hand, can help improve your credit scores. Setting up auto payments for your student loans can help to ensure you never miss a payment, giving you peace of mind while also potentially boosting your credit.
Keeping your credit utilization ratio low is another way to improve your credit scores. Your credit utilization ratio reflects how much of your available credit you're actually using. If you have a total credit limit of $9,000 on three credit cards and carry a balance of $750 on each (or $2,250 total), your credit utilization rate is 25%. A low credit utilization rate shows you're doing a good job of managing your debt. In general, it's recommended to keep your credit utilization rate under 30%—the lower, the better.
Reducing Your Student Loan Debt
If you want to buy a home in the near future and your DTI is too high to qualify for a mortgage, there are several steps you can take to reduce your student loan debt.
- Pay more toward your student loan every month. Cut back on discretionary spending, such as eating out or buying new clothes, and put the extra money toward your student loan payments. Paying a bit more on your student loan each month will gradually improve your DTI.
- Consider refinancing or consolidating your loans. If you have federal student loans, the U.S. Department of Education offers a loan consolidation program that combines all of your federal student loans into one loan with one monthly payment. Although it won't lower your interest rate, federal student loan consolidation can make it easier to keep track of your debt and make your payments on time. It can also give you access to more flexible repayment plans. If you have private student loans, investigate loan consolidation and refinancing options offered by banks, credit unions and online lenders. Be aware that if your credit scores and DTI are less than stellar, it may be difficult to refinance student loans at a lower interest rate than you currently have. Learn more about refinancing and consolidating student loans.
- Make more income. See if you can get a raise at your current job, take on a part-time job or start a side hustle to earn extra money. In addition to improving your DTI, increasing your gross monthly income can help you save more money toward a down payment or pay more toward your student loan each month.
- Look for a new job that offers assistance with student loan debt. Student loan debt repayment assistance has become a popular employee benefit, and is now offered by hundreds of companies nationwide. If you're open to a job change, finding a company that will help with your student loans can make a big difference to your debt load. (Keep in mind that mortgage lenders generally want to see a job history of at least two years with the same employer, so don't use this tactic unless you're willing to wait two years to apply for a mortgage.)
All of these steps take time, but be patient. Eventually, small changes will have big results, leaving you better positioned to manage the responsibility of a mortgage.
Other Factors for Getting Approved for a Mortgage
Your DTI and credit scores aren't the only factors lenders consider when approving your mortgage application. To help compensate for less-than-ideal numbers, you can:
- Make a higher down payment. Although 20% is generally considered the ideal down payment amount, in 2018, the median down payment for all home buyers was 13%, and for new home buyers, it was 7%, NAR reports. Have your parents or other family members offered to give you money to use for your down payment? Take them up on it. Keep in mind that your lender may set limits on the percentage of the down payment that can be gifted; they will also require documentation, such as a gift letter, to prove that the money is a gift rather than a loan.
- Use a first-time homebuyer program. U.S. Federal Housing Administration (FHA) home loans, Veterans Administration loans, U.S. Department of Agriculture home loans and Fannie Mae HomeReady loans are among the mortgage loan programs designed specifically to help first-time buyers buy homes with low down payments and less-than-stellar credit scores. Learn more about mortgage programs for first-time home buyers.
To the mortgage lender, it all boils down to this: Do you have enough income to manage all of your monthly payments without getting in over your head? When you're eager to own your own home, it can be difficult to remember that mortgage lenders ultimately have your best interests in mind. By taking time to increase your income, lower your DTI and improve your credit scores, you'll learn the skills you need to responsibly manage a monthly mortgage payment.