Even in the best circumstances, getting through the mortgage underwriting process can be a long, complicated process. When student loans get added to the equation, things get even more complicated. The good news is that mortgage lenders have gotten progressively better about dealing with student loans over the last couple of years. The bad news is that many mortgage lenders do not fully understand student loan rules.
Today we will discuss the many ways that student loans can make buying a house more difficult. We will also cover various tactics to fix student debt so that it does not cause a mortgage application denial.
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 applicant’s ability to pay their bills. DTI compares your monthly bills to monthly income, hence the term debt-to-income ratio.
There are two DTI numbers that lenders will consider. The first is called the front-end ratio. The front-end ratio compares an applicant’s expected mortgage to their monthly income.
The math on a front-end ratio calculation is relatively simple. Lenders will take expected housing costs, including principal and interest, taxes, and insurance, and divide it by an applicant’s 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 a front-end ratio of less than 28%, but some will go up to 31% or even higher in certain circumstances. Student loans do 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%. However, the maximum back-end ratio will move up or down depending upon the applicant’s credit profile. Some lenders may even approve over 50%.
The back-end ratio includes the following monthly bills:
The back-end ratio DOES NOT include the following monthly bills:
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 typically get each month.
Fixing the back-end DTI isn’t an easy task. Most borrowers can’t just snap their fingers and have less debt.
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, and the better the DTI becomes.
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. According to the federal loan repayment simulator, the number used in the DTI calculation 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, by switching repayment plans, a borrower can improve their DTI.
Eliminate Smaller Balances – Lowering the balance won’t help on some loans, but paying off an entire balance will make a huge difference. Typically, we suggest that borrowers pay down their highest interest debts first. However, a notable exception is for borrowers 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…
Student loan refinancing is when a borrower finds a lender 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. If someone uses a refinance to qualify for a mortgage, the objective is to get a smaller monthly 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 different than 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 its 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 – Work with multiple lenders. Each lender evaluates applications differently according to their 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 to help a mortgage application, be sure to do it long before applying for the mortgage.
Find the Best Long-Term Rate – If you are refinancing to get lower payments for a mortgage application, you want a longer 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 a 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 creative way to work the system, but it comes with risk as borrowers must bet on future approvals.
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.
Student loans can also impact credit scores. On the positive side, a student loan can be a borrower’s oldest credit line. A longer credit history will help the credit score. Making payments on time can improve 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. It is normally hard to predict the exact nature of the score change. By paying off several loans and combining them into one new loan, credit scores can often rise. However, because the oldest line of credit for some borrowers is their student loans, credit age can change negatively.
Additionally, applying to refinance can also cause a small dip in the credit score. Multiple applications count the same as a single application because the credit agencies consider this as shopping around. For this reason, it is crucial to make any student loan moves well in advance of the mortgage application. This will ensure that any potential negative impacts are minimal while 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 adverse 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:
Where the mortgage brokers and lenders can 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 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 mortgage experts can often lack the necessary expertise is with student loans. Many mortgage lenders don’t fully understand how federal income-driven repayment plans work, and it can make the underwriting process more difficult.
Mortgage underwriting is the process by which a lender evaluates the finances of an applicant to determine whether or not they should offer a loan. This process also determines the interest rate as well as the 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 the payments could go up. Therefore, they concluded, 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. Borrowers making more money 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. Most smaller lenders, like local credit unions and regional banks, also 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 of different companies. If one of the lenders decides that they are afraid of the student debt at the last minute, you will have another option already in place.
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 in DTI calculations, even if the mortgage applicant isn’t the one who makes the payments.
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 while, usually 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.
The following steps could help qualify for a home loan. It can take a couple of months for student loan changes to be reflected in a credit report, so plan ahead.
Visit the Federal Repayment Simulator – Review the repayment plan options to get the lowest monthly payment.
Refinance Private Loans – The best way to improve debt-to-income ratios for private loan debt is to pick a 20-year loan at the lowest interest rate possible. Borrowers can always refinance again, after securing a mortgage.
Try to get a Co-Signer Release – If you have co-signed a student loan for someone else, getting removed from that loan should be a priority.