With current mortgage rates at historic lows, you may want to consider buying a home soon if you are ready to take that step. But if you have student loan debt, you may be wondering whether it could affect your ability to get a great deal on a mortgage, or even to buy a home at all. While it is true that too much existing debt is likely to affect your interest rate and even whether you qualify for a mortgage, in most cases you can — and should — still consider buying a home if you are ready.
Student loans don’t affect your ability to get a mortgage any differently than other types of debt you may have, including auto loans and credit card debt. When you apply for a mortgage, your lender will assess all of your existing monthly payment obligations, including student loans, to determine whether you would be able to manage the additional monthly payment. Depending on your situation, the lender will decide whether you qualify for the new loan, and if so at what interest rate.
For that reason, you should consider how both your monthly student loan payment and a hypothetical mortgage payment could affect your debt-to-income ratio and overall credit score before you apply for a mortgage. In other words, if you have any existing debt, you need to be careful that you will be able to manage all your monthly payment obligations with your current income.
This calculation varies a bit depending on the type of mortgage loan you choose.
Potential homebuyers can choose between a conventional mortgage from a private lender, like a bank or other financial institution, or an FHA loan, which is a mortgage backed and insured by the Federal Housing Administration for people with limited savings or lower credit scores. This backing enables the lender to offer you a better deal, which typically includes a lower minimum down payment and easier credit qualifying. Recent changes to the way lenders must calculate monthly student loan payments can make the FHA loan a more attractive option for those with student loan debt, particularly first-time homebuyers.
As you consider the options, here are some things you need to know about your debt-to-income ratio and credit score.
When you apply for a home loan, lenders use your debt-to-income ratio as a metric to assess whether you would be able to manage all of your debt obligations and make your monthly payments on the new loan.
The lender calculates your debt-to-income ratio by adding up all your existing monthly debt payments and your expected mortgage amount. That number is then divided by your gross monthly income, or the amount that you earn before taxes and other deductions, to determine what your debt-to-income ratio would be.
You can do this calculation before you apply for a mortgage to better understand whether you may qualify. For example, if you pay $500 a month for your auto loan, $200 a month for your student loans and want to buy a house that would have a monthly mortgage payment of $1,300, your monthly debt payments would total $2,000. If your gross monthly income is $6,000, then your debt-to-income ratio is about 33% based on the $2,000 figure.
For purposes of this calculation, debt payments are regular payments that you are obligated to make to repay money that you have borrowed. They include student loans, auto loans, credit card debt and mortgages, for example. Other monthly expenses, like utilities and grocery bills, are not included in this calculation.
Most lenders will not approve a mortgage if an applicant’s debt-to-income ratio exceeds 43%. Ideally, it should be at or under 36%, with the maximum for monthly mortgage-related payments under 28%, experts say.
The key thing to know is that the amount you pay each month is what matters in this calculation, not the overall amount of debt you have. If you find that you have a debt-to-income ratio that is too high to qualify for the mortgage you are seeking, note that federal student loans offer some flexibility about the amount you pay each month. For example, you could try switching your student loan repayment plan from standard to graduated or extended to see whether the lower payment reduces your debt-to-income ratio.
Just keep in mind that lowering your monthly payment on student loans could increase the amount that you will pay over time if you pay the loan for a longer period of time and accrue more interest.
For those considering an FHA loan, changes were announced in June 2021 that affect the way student loan debt is calculated in the debt-to-income ratio and make it easier for some potential homebuyers with student loan debt to access FHA loans. Under the old guidelines, FHA lenders were required to calculate a borrower’s monthly student loan payment at 1% of the outstanding student loan balance. Under the new policy, the monthly payment amount used in the debt-to-income ratio calculation is the same as a potential homebuyer’s actual student loan payment, which is often lower.
According to the FHA, approved lenders may implement these changes immediately , but must do so by Aug. 16, 2021.
Existing debt, including student loans, can also affect your ability to qualify for a mortgage because lenders also look at your credit score. You build credit and improve your credit score by consistently making your existing monthly payments on time, including student loan payments.
Lenders use your credit score and history to assess the amount of risk they would take on by giving you a loan. A high credit score with no record of delinquencies or defaults gives lenders confidence that you will repay your new loan on time, while a low credit score with a record of late or inconsistent payments may make the lender more hesitant.
Lenders use your credit score to help decide whether you qualify for a mortgage, as well as to determine the loan’s interest rate. Borrowers with higher credit scores are usually eligible for lower interest rates, while interest rates increase for borrowers with lower credit scores.
You can check your credit score before applying for a mortgage through your bank or at AnnualCreditReport.com, which is monitored by the Federal Trade Commission and the Consumer Financial Protection Bureau. If you have a low credit score, consistently making your student loan payments on time is a great way to build and improve your credit and to get a mortgage — with a good interest rate.
A low credit score might be another reason to consider an FHA loan. FHA loans are available to individuals with credit scores as low as 500 if they are able to afford a 10% down payment. Still, if you have experienced a bankruptcy event, at least two years must have passed, and you must demonstrate you are working toward establishing good credit.
With an FHA loan, a low credit score will still affect the interest rate you are offered, so you may end up paying a higher rate on your mortgage. Furthermore, keep in mind that if you’re delinquent on your federal student loans, you likely will not qualify for an FHA loan.
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Update 07/28/21: This article has been updated with new information.