The dream of many, as well as the most common way for Americans to build wealth, is buying a home. That is becoming more and more of a dream for those graduating with massive student loan debt. This article discusses high student loan debt and buying a house. Specifically, we discuss one key strategy that can help you qualify for a home loan.
- High Student Debt and Buying A House: The Major Problem
- A Grad School Example
- One Way To Improve Your Situation
- Bad News, Good news
High Student Debt and Buying A House: The Major Problem
According to CNBC, 83% of people ages 22-35 who haven’t bought a home blame their student loans. One of the reason is they can’t qualify for a home loan.
The reason why they can't qualify is is their debt-to-income ratio (DTI). Below is an example of why that is. Further in the article we explain a way to potentially help you qualify for a mortgage by “optimizing” your DTI ratio.
First things first though, what is DTI. It is your total debt obligation divided by total gross earnings. By total we mean all monthly payments on debt... Student loans, auto loans, credit cards, etc... When you are buying a home, the lender includes the mortgage payment, property tax, home owners insurance and HOAs into this calculation.
To qualify for a mortgage your DTI ratio can not be more than 35% - 50%. Below is an example that illustrates the DTI calculation. (Note: Your actual DTI for qualification is based on a number of factors so this number will very).
A Grad School Example
An individual with a graduate degree used to be an automatic to qualify for a mortgage. However, that has changed.
For the following example, we will use actual data we have collected from FitBUX members.
Let’s assume a recent graduate is making $70,000 a year (i.e. $5,833/months). The graduate has $145,000 in student debt. Their monthly required payment under the standard 10 year student loan repayment plan $1,632. Let’s also assume that she has no other debt or source of income.
Her DTI ratio would then be 28% ($1,632/$5,833).
Let’s say she wants to buy the home of her dreams. Since she has high student loan debt and is buying a house, she needs to apply for a mortgage. We’ll assume lenders will not let our new graduate have a DTI ratio greater than 40%.
This means that her home mortgage, taxes, homeowners insurance, PMI, and HOA fees must be 12% of her income or less. (40%-28%= 12%)
Let's assume that she would use the full 12% just for her mortgage. Thus, 12% of her $70,000 salary is $8,400 per year. Therefore, her mortgage which equals to $700 per month.
Assuming a 30-year mortgage (Principal and Interest) at 5%, she would only qualify for a mortgage of $130,000. Once you account for property taxes and homeowners insurance, that number will be even less of course.
One Way To Improve Your Situation
Although you may “feel” that you can afford more, the lender does not. Unfortunately, your lender won’t take your “feelings” into consideration. All they care about is what the "numbers" are.
One way to make your "numbers" look better is to reduce your required monthly payment on your student loan. You can do this by using the extended standard repayment plan on your Federal loans. If you have private loans, you can try refinancing them into a longer term or extending the term with the existing lender.
Taking the above actions will decrease your required monthly payment since you’ll be paying off your loans over a longer period of time.
Note: The extended standard repayment plan for Federal Loans the standard 10-year loan to 25 years (keeping the same interest rate). If you decide to extend private loans, the interest rate would be different.
Using our example, extending all loans to 25 years while keeping the same interest rate would reduce the total required payment from $1,632 down to $962.
The new DTI ratio would then be 16% ($962/$5,833), with 24% available to secure a mortgage. All else being equal, our recent graduate would now qualify for a mortgage of $255,000.
One extra thing you can do is refinance your high interest rate loans into a 20 year to save money. Then refinance again after you buy the house. To learn more about refinancing check out our student loan refinancing guide.
Bad News, Good news
One thing to keep in mind when considering extending loans is you could end up making payments for a long-time. Therefore, you end up repaying a lot more overall due to the longer term. That’s the bad news. To neutralize this, it is important to build a strategy where you will make additional prepayments. This will help you repay your loans faster and pay less interest.
The good news is that by making additional voluntary payments, you would be able to 1) target the highest-interest loan first, hence decreasing interest payments overall, and 2) decrease your total required payment each time a specific loan is paid off. By reducing your required monthly payment, you would further improve your DTI as well.
If you'd like to learn more, be sure to check out FitBUX's money blog.