Q: I am in a position where I would like to buy my first home but I have some student loans that I’m worried about. Right now, I am on the income-driven repayment (IDR) plan, will this be an issue I need to consider before taking the leap to homeownership?
A: Dear reader,
It’s definitely wise to consider your student loans if you plan to become a homeowner in the future. Getting approved for a mortgage depends on multiple factors beyond your student loans. These factors can include things like your debt-to-income ratio (DTI), credit score, the type of mortgage, the lender, and how much you have saved for the down payment. Since I don’t have many details about your situation, I will give you general information about how to prepare to take this big step when you have student loans.
The biggest impact your student loans can have on your mortgage application is how they affect your income-to-debt ratio. Lenders calculate your DTI to determine if and how much you can afford to pay on a monthly mortgage. They will determine your front-end-ratio by dividing an estimated monthly mortgage payment by your gross monthly income (your income without the taxes and deductions). Lenders usually look for a 28—36% front-end ratio, but the actual threshold depends on the lender and type of mortgage you want (like an FHA or conventional loan). Your back-end ratio is more important and it is calculated in a similar fashion. And here is when your student’s loans come into play because they are factored in the calculation. The back-end ratio is calculated adding all of your expenses and dividing them by your gross monthly income. Generally, lenders look for a 43% back-end ratio or lower, but some private lenders may go higher, even to 50%, especially if you can compensate with a solid credit score.
Since you mentioned that you are currently enrolled in IDR, you should consider how that might impact a mortgage application. Fannie Mae recently issued updated guidance for prospective mortgage borrowers on IDR. This guidance states that lenders can consider the payment amount that appears on your credit report for your student loans in IDR when calculating your DTI. If no payment level is indicated in your credit report, the lender will calculate 1% of your outstanding balance as your student loan payment for DTI purposes.
Purchasing a home is about long-term planning. Therefore, you should consider what you might expect to happen to your student loan payments in the future before committing to a mortgage. This is especially important for borrowers in IDR because your student loan payment is tied to your current level of income. So if your income increases in the future, your monthly payments are likely to increase as well. If you have questions about how your future student loan payments might impact your budget, or whether a different repayment plan might be a better fit for your future plans, consider speaking with a nonprofit credit counselor about your plans.
Your credit score also is an important determining factor used by mortgage lenders. Even if you have student loans on an income-driven repayment plan, you can have a high score. A good strategy to raise your credit score is to always pay your credit cards/loans on time, limit the new credit solicitations, and keep your utilization ratio low. The utilization ratio is how much of your credit you use in comparison to how much available credit you have. An industry standard is to use about 30% of your available credit. Other determining factors considered by lenders are how much you have for a down payment and for how long you’ve been employed in the same line of work. Lenders want to make sure that you have a steady income to meet all of your financial commitments to avoid a foreclosure in the future.
Just remember that your student loans alone can’t prevent you from qualifying for a mortgage, but their effect on your DTI can. But, this is also true about any big debt that you have. Before you shop around for mortgages, review your credit scores and calculate your debt-to-income ratio so that you have a better idea of where you stand. If you are not where you should be, don’t despair, make a plan and get ready. You want to make sure that when you take this step, you can afford your mortgage and all of your obligations without straining your finances. Homeownership begins with buying your home, but it continues by maintaining it.
Matt Ribe, Senior Director of Legislative Affairs and Corporate Secretary
Matt Ribe is the Senior Director of Legislative Affairs and Corporate Secretary for the National Foundation for Credit Counseling (NFCC). At the NFCC, he is responsible for government relations at the state and federal level as well as managing the organization’s Board of Trustees and member governance committees. Ribe is heavily involved in the Coalition of HUD Intermediaries, where he serves as co-chair of the Advocacy Committee. Well versed in the federal student lending programs, Ribe serves as the NFCC’s Subject Matter Expert on student loans and has appeared on ABC News 7 in Chicago and other news publications.