For many people saddled with Student Loan debt, the dream of home ownership seems like something that will never happen. For some, just having enough money to pay the bills for a month seems like a dream that will never happen.
If you are serious about purchasing a home and you have a lot of student loan debt, it will take some serious sacrifice. However, if you are smart about it, your dream of home ownership can be realized.
Student loans make buying a home difficult for two reasons. First, lots of student debt, especially if you fall behind, can be devastating to your credit score. Second, student loans crush your home-buying power due to their affect on your debt-to-income ratio.
Part One: Clean up your credit score
This one is the obvious one. If you have a credit score littered with late payments or worse yet, defaults and delinquencies, you will have a tough time getting a home loan. Fortunately, many programs exist to help student loan borrowers get their payments back on track. The federal government has a variety of repayment plans, including some that depend upon your income. If you don’t make much money, your monthly payment won’t cost much money. Even some private lenders have created plans to help borrowers get their debt back on track. The key here is keeping in contact with your lenders and making sure nothing slips through the cracks.
Student loans are not the only reason that cause people to have a bad credit score, so its important to keep up on all your bills and keep an eye on your credit report. Whether its your mistake or someone else’s, it can hurt your ability to get a home.
However, even if you have a great credit score, or even a “perfect” credit score, student loans can still get in the way of buying a home.
Part Two: Improve your debt to income ratio
This is the part where getting creative with your budget and your bills can make a huge difference in your ability to buy a home.
For those not familiar, the debt to income ratio looks at your monthly salary compared to your debt. This examination takes place in two ways. First, a mortgage broker will look at your monthly income compared to the monthly mortgage payment you would like. This is called the front-end ratio. Student Loans have no affect on the front-end ratio, so they are not a concern. The second part of the debt to income ratio is where student loans make things difficult. This part is called the back-end ratio. The back-end ratio looks at your monthly income compared to all of your monthly payments. These payments include credit card bills, car payments, and yes, student loans. (FYI: Monthly payments like a cell phone or car insurance are not included)
Currently, to get an FHA loan (one of the more common loans for first time homebuyers) the front-end ratio should be less than 31% and the back-end should be under 43%. This means that if you make $4,000 a month, your mortgage would have to be under $1,240 a month, and all of your monthly debt obligation needs to be under $1,720. Put another way, if you are currently spending more than 12% of your income on student loans, they are hurting your ability to buy a home.
Getting this fixed is where some creativity gets involved. You may want to get with a mortgage professional to discuss some plans of action, but there are a couple different things you can do to fix your back-end ratio.
Refinance Debt: If you lower your interest rate or extend the duration of a loan, your monthly payment goes down. This applies to student loans, car payments, and credit card debt. Locking in a lower monthly payment improves your back end ratio.
Realize where putting extra money lowers payments: If you have a car payment and credit card debt it may seem like paying extra towards either form of debt would help your creditworthiness. However, only one “extra” payment will make a difference. The minimum monthly credit card payment is calculated based upon your credit card balance. As your balance goes down, the minimum payment goes down, and your back-end ratio improves. Car payments, and student loans are different. They are all or nothing. Even if you pay off 75% of your student loan, your minimum monthly payment will still be the same amount. Thus, most mortgage companies won’t care whether the debt is 1% paid off or 50% paid off. If it is a monthly bill it hurts your ratio.
Get smart about what you pay off first: To pay off debt the fastest it is usually recommended that you pay off the highest interest rate debt first. This is clearly a very good practice, but it is not necessarily the fastest route to getting a new home. For some, knocking off their smallest loan might be enough to get under required back-end ratio. If you are sitting on three student loans, the highest interest one might also be the one that has the largest balance, so their is sound logic in putting extra money towards that one. However, if you can get your smallest loan paid in full, an entire monthly payment disappears. If you are right on the board of the required 43%, it could get you over the top.
Get rid of co-signers: If at any point you co-signed a loan for someone, getting released from that loan can make a huge difference. Technically, if the borrower you co-signed for is making all of their payments it should not hurt your ability to buy. However, with many decisions being automated, the co-signed loan that appears on your credit report still could hurt you. If you co-signed a loan, this article on co-signer release could make a difference in your ability to qualify.
Buying a home requires a lot of long term planning for those with student loans. Because there are a number of strategies that you can employ to make yourself a better mortgage candidate, it is critical that you take an honest, hard look at your finances and put together a realistic plan. If you plan smart and stick to your plan, home ownership can be a reality.