Rising interest rates and home prices have made it especially difficult for student loan borrowers to qualify for a mortgage.
If there is good news in this challenging situation, many borrowers can take simple steps to improve their application.
Picking the right student loan repayment plan isn’t just about keeping things affordable or qualifying for loan forgiveness. The right student loan repayment selection can turn a mortgage application rejection into an approval.
Debt-to-Income Ratios: The Reason Repayment Plan Selection is Critical
One of the most important figures on any mortgage application is the debt-to-income ratio.
The Debt-to-Income Ratio or DTI looks at a would-be borrower’s monthly income compared to their monthly debts. Many people mistakenly assume that this number is pretty much set in stone. Fortunately, student loan borrowers can improve their DTI without paying off a loan in full or getting a raise.
Because mortgage companies use credit reports to determine debts, the monthly bill reported by lenders and federal servicers is critical. Thus, picking the right repayment plan can make a massive difference in the DTI analysis.
Sherpa Thought: At the risk of repeating myself, borrowers must understand that monthly debts and income matter far more than total debt or yearly income.
In other words, a borrower with a $500 monthly bill for a $5,000 loan balance will get treated the same as a borrower with a $500 monthly bill for a $100,000 loan balance.
It might sound ridiculous, but mortgage companies follow strict standards and formulas when underwriting. The monthly payment is critical, and the interest rate and total balance don’t really matter.
The New SAVE Plan Makes it Easier to Buy a Home
Borrowers get to keep a larger percentage of their income, and the discretionary-income calculation has been further tweaked in favor of borrowers.
For many, the result is a much more affordable monthly payment.
What if I want to pay more each month so I don’t spend a ton of money on student loan interest? Some borrowers have avoided SAVE because they wish to pay off their debt quickly.
However, this approach is usually a mistake. Borrowers can pay extra toward their federal loans whenever they want. The monthly bill is the minimum monthly payment. There isn’t a penalty for paying extra to knock out the debt faster.
Changing IDR Payments and Mortgage Lender Nonsense
Historically, some mortgage lenders refused to accept monthly payments on IDR plans like SAVE. They reasoned that because the IDR payment could go up, it wasn’t a reliable number to use for DTI analysis.
Thankfully, common sense has mostly prevailed. Lenders now recognize that a monthly payment would only increase if the borrower earned more money.
However, it is worth noting that different banks and lenders may have unique rules and standards. The policies outlined in this article apply to most lenders, but your local bank or credit union might have a strange student loan policy. If that is the case, moving on to a more reasonable lender is often the easiest fix.
The Danger of Income-Driven Repayment Plans like SAVE
Even though most lenders will now accept IDR payments for DTI calculations, there is one circumstance where they revert back to the older and more harsh rules.
If you qualify for $0 per month student loan payments, many lenders will refuse to accept the $0 payment for DTI calculations. Instead, they will use .5% or 1% of the total loan balance. For example, a borrower with a $0 per month payment and a $50,000 student loan balance will get treated as though they have to pay $500 or $250 per month on their student loan.
For borrowers with sizeable federal student loan balances, qualifying for a $0 per month payment may tank a mortgage application.
Thus, if you are going to apply for a mortgage in the next year, the best repayment plan to select is the one with the lowest monthly payment, as long as it is above $0.
To see projected payments across all federal repayment plans, use the Department of Education Loan Simulator.
Plan Selection Alert: Some borrowers may find that the graduated or extended repayment plans offer the lowest monthly payment and best chances at a mortgage approval.
Because these older plans do not qualify for PSLF or IDR forgiveness, borrowers who use these plans for mortgage applications should switch back to their desired IDR plan as soon as the home closes.
Don’t switch back too early and have it mess up your closing. Running a credit check just before signing is common, and a new loan or new payment can cause issues.
Repayment Plan Selection for Private Loans
Private loans are notoriously more difficult than federal loans when it comes to repayment plan selection.
Income-driven repayment plans are not available, and borrowers have little say in their monthly bills.
A deferment or forbearance usually doesn’t help because mortgage lenders will use .5% or 1% of the loan balance for DTI calculations.
Despite these limitations, calling your private lender to ask about repayment plan options is often helpful. Switching from a 5-year repayment length to a 10-year repayment length would mean a significant drop in your monthly bill. Just be sure that your private lender reports the new lower monthly payment to the credit bureaus.
Digging Deeper: Tweaking monthly payments by selecting a new repayment plan isn’t the only move available to student loan borrowers who want to buy a home. Other strategies to prepare student debt for mortgage applications include removing cosigners and targeting individual loans.
Refinancing Private Loans for a Better DTI
One option to dramatically reduce the monthly bill on private loans is to refinance the debt.
Suppose a borrower has a $30,000 private student loan on a 10-year repayment plan. If the interest rate is 6%, the monthly payment will be just over $333. If that same loan gets refinanced into a 20-year loan at the same interest rate, the monthly payment drops to about $215.
Reducing the monthly bill by over $100 means the borrower can qualify for a large home loan. It could even be the difference between an approval or a rejection of a mortgage application.
The downside to this approach is that opting for a longer loan can sometimes mean a slightly higher interest rate.
Additionally, borrowers should use this option with care. Waiting until the last second to refinance your private loans can complicate the underwriting process on the home loan. Generally speaking, it is best to refinance at least a couple of months before starting mortgage applications. Talk with your desired lender to figure out an ideal timeline.
As of December, 2023, the following lenders offer the best interest rates on 20-year fixed-rate student loans:
|Rank||Lender||Lowest Rate||Sherpa Review|
|1||6.08%*||Splash Financial Review|