consequences of student debt on mortgage applications

Advanced Mortgage Strategy for Student Loan Borrowers

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  • Student loans can affect a mortgage applicants debt-to-income ratio and credit score.
  • Student loan refinancing and other strategies can minimize the damage from student loans.
  • Mortgage underwriters have historically been hard on income-driven borrowers, but things are getting better.
  • Student loan co-signers can also have problems caused by students loans borrowed for someone else.
In even the best of circumstances, getting through the mortgage underwriting process can be a long difficult process.  When student loans get added to the equation things get even more complicated.  The good news is that over the last couple of years mortgage lenders have gotten progressively better about dealing with student loans.  The bad news is that there are still some aspects that make student loans unique that not all mortgage lenders fully understand.

Today we will discuss the many ways that student loans can make buying a house more difficult.  We will also cover various tactics and strategies to make sure that student debt doesn’t derail the dream of home ownership.

Student Loans and the Debt-to-Income Ratio (DTI)

The debt-to-income ratio or DTI is one of the most important numbers in the mortgage application process.  The DTI is how a lender evaluates a mortgage applicants ability to pay their bills.  DTI compares your monthly bills to monthly income, hence the term debt-to-income ratio.

There are actually two DTI numbers that lenders will consider.  The first is called the front-end ratio.  The front-end ratio compares an applicants expected mortgage to their monthly income.

The math on a front-end ratio calculation is fairly simple.  Lenders will take expected housing costs, including principal and interest, taxes, and insurance and divide it by an applicants monthly income before taxes.  This calculator is an excellent tool for estimating housing costs.  If the total housing costs will be $1000 per month and an applicant makes $5,000 per month, the front-end ratio will be .20 or 20%.  Most mortgage companies want the font-end ratio to be less than 28%, but some will go up to 31% or potentially higher in certain circumstances.  Student loans will not impact the front-end ratio.

The DTI number that causes headaches for student loan borrowers is called the back-end ratio.  Instead of just looking at the housing costs, the back-end ratio looks at all monthly expenses compared to monthly income.

The math on the back-end ratio works the same way, only the back-end calculation includes monthly student loan bills, car payments, other monthly bills, and housing costs.  Lenders will look for the back-end ratio to be less than .41 or 41%, but this number can drop based upon credit history or be increased for applicants who have excellent credit or other assets.  Some will go over 50%.

The following monthly bills are included in the back-end ratio:

  • housing expenses
  • car payments
  • student loan bills
  • minimum monthly payments on credit cards
  • any other debt that appears on a credit report

The following monthly bills are NOT included in the back-end ratio:

  • utility bills
  • food and groceries
  • cell phone bill
  • cable bills
  • retirement plan contributions such as an IRA, 401(k) or Roth
  • most subscriptions

One final note on back-end DTI calculations: Lenders usually will take yearly income and divide it by 12.  Those who get paid every two weeks will use a number slightly higher than the two paychecks they normally get each month.

Strategies to Improve Debt-to-Income Ratios

Fixing the back-end DTI isn’t an easy task.  Most borrowers can’t just snap their fingers and owe less money.  Making more money can likewise be quite difficult.

However, there are ways to tweak the DTI to lower your ratio.

Pay Down Credit Card Balances – With most debts, paying down a balance will not help.  If you pay extra towards your car payment, the monthly payment remains the same.  That means the DTI stays the same.  When it comes to credit cards, paying down the balance will lower your minimum monthly payment.  The smaller the balance, the smaller the payment, the better the DTI becomes.  Best of all, if you pay your credit card balance in full each month, it will not impact your DTI.

If you are going to change repayment plans to help your mortgage application be sure to do so many months in advance.  Processing the application and having it show up on the credit report take time.
Tweak Repayment Options – One of the great perks of having federal student loans is the variety of available repayment plans. Suppose a borrower has $35,000 in federal student loans and they are on the standard repayment plan.  The number used in the DTI calculation, according to the loan repayment estimator, would be $389.  If that borrower switches to the graduated repayment plan, the number drops to $222 per month.  Should the borrower enroll in the REPAYE or PAYE plan, they can lower their monthly payment to $182 per month.  Even though the student loan balance has not changed at all, by switching repayment plans a borrower can improve their DTI.

Eliminate Smaller Balances – Paying down a balance may not make a difference, but paying off a balance entirely will make a huge difference.  Normally we suggest that borrowers pay down their highest interest debts first.  One exception would be if they are trying to improve their DTI for a mortgage application.  By paying off a smaller loan in full, even if it is a low-interest loan, the monthly payment disappears from the credit report.  One less debt means a smaller DTI.

Another option to improve DTI that costs nothing is to refinance student loans…

Refinancing Student Loans for Mortgage Applications

Student loan refinancing is when a borrower finds a lender who is willing to pay off some or all of the borrower’s old student loans.  The borrower then repays the new lender according to terms of a new borrower contract.

Traditionally this process is done by borrowers looking to secure a lower interest rate on their student loans.  In the case of someone using a refinance to qualify for a mortgage, the objective is to get a lower payment.  Getting a lower interest rate helps with this goal, but extending the repayment term will also make a big difference.  A 20-year loan will have much lower payments than a 10-year loan.

It should be noted that refinancing student loans is much different than just temporarily picking a new repayment plan.  Before refinancing, borrowers should consider several different factors:

Be Extra Careful with Federal Loans – Federal student loans have excellent borrower perks like income-driven repayment plans and Student Loan Forgiveness.  By going through a private student loan refinance, any federal loan permanently loses their federal perks.  Borrowers should only refinance federal loans if they are certain they will be paying back the loan in full without the need for any of the federal programs.

Shop Around – It is critical not to just pick one company to refinance with.  Each lender evaluates applications differently according to their own formulas.  Checking rates with several different companies will ensure you get the best deal.  Right now there are nearly 20 different lenders offering refinancing services.  We suggest applying with at least five.

Don’t Delay – The entire refinance process can easily take over a month.  Getting approved takes time.  Having your new lender pay off the old debts takes time.  Waiting for the credit report to show the old loans paid off takes time.  If you are going to refinance in order to help a mortgage application, be sure to do it long before you actually apply for the mortgage.

Find the Best Long-Term Rate – If you are refinancing to get lower payments for a mortgage application, you want a long repayment plan.  The interest rate will be slightly higher, but the payments will be much lower.  Keep in mind that the companies advertising the lowest rates are usually promoting their short-term loans.  Focus on the lenders who have the best 20-year refinance rates.

Multiple Refinances – As you plan your strategy, remember that there is nothing wrong with refinancing your student loans multiple times.  Borrowers may opt for the long-term loan when they are getting ready to get a mortgage and refinance a second time after purchasing the house to lock in a lower interest rate.  This strategy can be a very clever way to work the system, but it comes with risk as borrowers must bet on future approvals.

Mortgage Applications, Student Loans, and Credit Scores

The two biggest factors in a mortgage application are the debt-to-income ration and credit score.  Thus far, we have focused primarily on the DTI as this is typically how student loans impact a mortgage application.

Credit scores can also be impacted by student loans.  On the positive side, a student loan can be a borrowers oldest line of credit, which is a good thing, and making payments on time can help a credit score.  On the negative side, late payments and other student loan issues can damage a credit score.

Refinancing can help or hurt a credit score.  In the vast majority of cases the impact on credit score is low in either direction, but it is normally hard to predict the exact nature of the impact.  By paying off several loans and combining into one new loan, credit scores can often rise.  However, because the oldest line of credit for some borrowers is their student loans, their oldest line of credit can change for the negative.  Additionally, applying to refinance can also cause a small dip in the credit score.  Multiple applications do not hurt any further as the credit agencies consider this shopping around.  For this reason, it is important to make any student loan moves well in advance of the mortgage application.  This will ensure that any potential negative impacts are minimal while still allowing borrowers to take advantage of the positive consequences.

For borrowers who have excellent credit scores, the small variations from the refinance process are unlikely to impact the amount or interest rate on their mortgage.

Finally, if your lender has mistakenly reported any negative information to the credit agencies, be sure to get this negative reporting fixed as soon as possible.

Because credit scores can be complicated, it is often a good idea to consult an expert…

Working with Mortgage Brokers and Lenders

Mortgage brokers earn their living by helping people find mortgages.  Some are better than others and some are more reputable than others.  Finding someone skilled and experienced can make a big difference.

Mortgage experts will be able to help most student loan borrowers figure out where they stand.  They can help mortgage applicants answer the following questions:

  • What size mortgage will I qualify for?
  • Is my credit score going to be an issue?
  • What ways can I improve my DTI?
  • What price range should I be considering?

Where the mortgage brokers and lenders normally fall short is in helping borrowers make a responsible decision.  Determining how big a mortgage someone can qualify for is one thing, but determining whether or not it is a good idea is another matter.  Just because you can qualify for the mortgage does not mean you can afford it or that it is a good idea.

Another area where the mortgage experts can often lack the necessary expertise is with student loans.  Many lenders don’t fully understand how federal income-driven repayment plans work, and it can make the underwriting process more difficult.

Underwriting issues – Can I use IBR, PAYE or REPAYE Payments?

Mortgage underwriting is the process by which a lender evaluates the finances of an applicant to determine whether or not they should be offered a loan.  This process also determines interest rate as well as loan size.

The income-driven repayment plans of federal student loans have historically been a hurdle for borrowers looking to get a mortgage.  The good news is that most lenders are getting better about this issue.

In the past lenders would not accept income-driven payments because they reasons that the payments could go up, therefore it wasn’t an accurate number.  Student loan borrowers and advocates argued that the only reason these payments would go up is if the borrower was making more money.  In that instance they would be in a better position to repay their mortgage.

Nonetheless, for years borrowers were not able to use income-driven payments for DTI calculations.  Instead, lenders would replace the actual monthly payment with 1% of the loan balance.  For borrowers with larger debts, this would often shatter the DTI and lead to application rejections.

Mortgage giants like Freddie Mac and Fannie Mae have finally seen the light and are now more accepting of income-driven repayment plan payments for DTI calculations.  Smaller lenders like local credit unions and regional banks are also starting to follow the same improved rules.  However, not all lenders will accept IBR, PAYE or REPAYE payments into their DTI calculations.  For this reason, it is critical to communicate with your lender to determine how they evaluate income-driven payments on student loan applications.

We also suggest applying to get a mortgage with a couple different companies.  If one of the lenders decides at the last minute that they are afraid of the student debt, you will have another option already in place.

Co-Signer Issues on Mortgage Applications

Being a co-signer on a student loan can also impact your mortgage application.

Co-signed student loans appear on credit reports along with monthly payments.  As a result, most lenders include the co-signed loan payment even if the mortgage applicant isn’t the one who actually makes the payment.

Many lenders will remove the co-signed loan from the DTI calculation if the mortgage applicant can show that the student loan borrower has been making payments on their own for a period of time, normally 12 or 24 months.  However, with many mortgage applications being initially evaluated by a computer algorithm, co-signed loans can cause an application rejection, even if the primary borrower is caught up and never misses a payment.

Things get extra complicated for co-signers of borrowers who are still in school.  We have heard of lenders going so far as to initiate a three-way call between the mortgage applicant, the mortgage company, and the student loan company.  The mortgage company essentially asks the student loan company what the highest possible payment will be once the borrower enters repayment.  The mortgage company then uses that number in the DTI calculations.  Thus, a loan that a mortgage applicant may never have to pay can still dramatically alter their chances of approval.

If you are thinking about buying a house in the future, co-signing on student loans should probably be avoided if possible.

Final Thoughts

Student loans can have devastating consequences to any mortgage application.  Borrowers who get creative and plan ahead can usually find ways to ensure that student loans do not get in the way of home ownership aspirations.