If you’re worried your student loans will prevent you from buying your first home, don’t fret. Here’s what you need to know to land that first house.
What the mortgage company considers. Your potential lender will look at your FICO score, which can range from 300 to 850. A score above 650 is considered good. A score below 620 means you will have difficulty getting a loan at the best interest rates. The score is a compilation of your payment history, how much is owed, length of credit history along with other factors.
The lender will also look at your length of employment and will want to see your most recent pay statements. You’ll need to provide tax returns and statements from all your bank and investment accounts.
Your student loan debt and your payment history will show up on your credit report. The lender will figure it into your debt-to-income ratio calculation.
Your income and your debts. Debt-to-income ratio is a fundamental measurement that lenders use to judge a customer’s ability to pay back a proposed loan. There are two measures, one cursory, the other more in-depth.
A front-end debt-to-income ratio looks at the percentage of your monthly gross income that would be used to pay the total housing payment. Say your annual income is $60,000 or $5,000 gross per month. The monthly housing payment is calculated by adding principal, interest, taxes and insurance, known in the home-lending business as PITI. Let’s say that your PITI adds up to $1,400 per month. When you divide by $5,000 monthly income, that equates to 0.28 debt-to-income ratio. In other words, your mortgage payment would use 28 percent of your monthly gross income.
A back-end ratio digs deeper. It takes the monthly housing payment and adds to it your total monthly debt payments. Suppose you have a $350 per month student loan payment, and a $300 per month car payment. Add that to the proposed $1,400 housing payment and your total debt-to-income ratio on a $5,000 per month income rises to 0.41 or 41 percent of your gross income.
What does the mortgage company accept? The back-end ratio has more importance with the lender because it takes your whole debt picture into account. Lenders like to see a ratio of 36 percent or lower, but will sometimes accept a low-40s percentage, if you have a great credit score. A Federal Housing Administration (FHA) loan has more lenient qualification requirements, for example.
If your student loan is in deferment or on an income-driven repayment plan, FHA rules allow the lender to use 1 percent of the total loan balance as the number to use in figuring the loan-to-income ratio.
Improving your chances. A great payment history, with no missed or late payments, is a great way to boost your lending profile. Second, if at all possible, pay off some existing loans before you get to the mortgage shopping stage. Pay off a small loan first, then apply that money to another loan. Third, work hard and excel at your job, seeking advancement and pay raises. A solid income picture and career strength will improve the revenue side of the ratio.
Finally, save more cash for a down payment. If you can put 20 percent down and still have good cash reserves, you will more likely be approved. A down payment under 20 percent forces you to pay a monthly mortgage insurance premium (PMI) to protect the lender from default, which negatively impacts your debt-to-income ratio.