For many consumers, buying a house is a major financial and life milestone. However, student loan debt is preventing some millennials from making home purchases.
According to a Student Loan Hero survey, 41 percent of college-educated Americans with student loans have postponed buying a home because of their debt.
Having student loans won’t keep you from buying a house, although you should be comfortable with the idea of taking on a large amount of debt while still dealing with your student loans. Carefully consider your options, and decide what makes sense for your own financial situation.
Here’s what you need to do when buying a house with student loan debt:
1. Improve your credit score and check your credit report
The most important factor lenders consider when deciding whether or not to lend you money is your credit score. You can maintain a good credit score even if you have student loan debt.
In fact, your student loan debt probably won’t drag down your credit score unless you’ve been missing payments. Here’s how to boost your score ahead of applying for a mortgage:
- Pay your bills on time.
This is the most important factor in your credit score. Pay on time and in full, and you can build a solid financial reputation.
- Manage your credit utilization.
The ratio of your credit balances to your total available credit lines is your credit utilization. For example, if you have credit lines totaling $3,000 and your credit balances total $1,000, your credit utilization is 30 percent.
Ideally, you want to manage your credit utilization so you aren’t using more than 30 percent of your available credit.
- Don’t close old accounts.
You might think that closing a credit card account is the way to go when trying to fix your credit score, but this often isn’t the case.
An old account, especially if it is in good standing, can help your credit. The longer your credit history and the older the average age of your accounts, the better your credit score.
- Use different types of credit.
If you have a “thin file,” there isn’t much for lenders to make judgments about. A mix of revolving credit (like credit cards) and installment loans (like car payments or student loans) show that you can handle different types of debt.
You may have to pay for your credit score, but some credit card companies have started offering free access to a version of your credit score so you can get an idea of where you stand.
2. Decrease your debt-to-income (DTI) ratio
As with student loan refinancing, a mortgage lender will calculate your debt-to-income ratio to determine your ability to make monthly payments on the new mortgage.
When buying a house with student loan debt, you need to be aware of the impact your loans have. Many lenders follow what is called the 28/36 qualifying ratio to determine if you’re eligible for the best rates.
This means that you should spend no more than 28 percent of your gross monthly income on total housing expenses, and no more than 36 percent of total debt service (including the new mortgage payment).
You can still buy a home if you don’t meet the 28/36 rule, as many lenders will still loan you money if your DTI is high. But you have to decide if you’re really comfortable taking on a loan when you have a high DTI.
Reduce your DTI by paying down some of your debt or by increasing your income. Take a second job, get a side gig, or ask for a raise. Depending on your student loan situation, you might be able to refinance or consolidate your student loans to obtain a lower monthly payment.
Alternatively, you could enroll federal student loans into an income-based repayment program which can lower your monthly student loan payments. This improves your cash flow and can make your home a little more affordable on a monthly basis.
While refinancing or finding a new repayment plan may improve your DTI, it really depends on the type of mortgage you’re applying for.
Some mortgage underwriters base decisions on the percentage of your total student loan balance rather than using your monthly payment amounts under an income-driven repayment plan. If that’s the case, you might need to shop around for a lender if you want to ensure that you are approved for a loan.
3. Pre-approval and your home buying power
A pre-approval from a lender can help you see what the costs and down payment requirements are. To determine what you qualify for, a lender considers your two-year employment history, credit history, income, and assets.
Here are some important things to keep in mind as you apply for pre-approval when buying a house with student loan debt:
- A lender must look at most aspects of your financial history, at least in the short term. All funds need to be sourced and explained. Any large deposits outside of normal payroll will be closely scrutinized, and any major loans will be considered as well.
- Gifts from family are not unusual for first-time homebuyers. These, too need to be sourced and accompanied by a lender’s gift letter.
Lenders aren’t supposed to accept loans as down payments, so if a relative is lending you the money for a down payment it’s not going to work. The down payment needs to be a gift, and it should be from someone with whom you have a close relationship.
- Check with the lender to ensure that you’re giving all documents needed for a comprehensive decision on your pre-approval.
Some of the documents you need to submit are two years of W-2s, two years of federal tax returns, 30 days’ worth of pay stubs, and two months of asset statements (including bank and retirement account statements).
- If you are self-employed, you might need additional paperwork to verify your income. You could be required to go through an income audit, where an accountant reviews your records and verifies your income.
- More documents may be needed once the loan is underwritten. A lender usually requires tax returns and bank statements.
Once you have your pre-approval, you can use it to help gauge which homes you can afford. Additionally, sellers are likely to take you more seriously once you have a pre-approval in place because they know the bank has already committed to providing you with financing.
4. Consider down payment assistance programs
There are a number of down payment assistance programs that are acceptable to lenders. Many states and cities offer down payment assistance programs, and there are local programs that allow you to use sweat equity if you want to build a new home.
It’s also possible to take advantage of federal loan programs, even if you have student loans. You may qualify for an FHA loan, which would mean a down payment of as little as 3.5%.
If you choose to buy in a more rural area, you might qualify for a USDA loan, which requires no down payment. Don’t forget about VA loans if you have served in the military.
Research your options and speak with a knowledgeable mortgage broker to find out what programs you qualify for at a federal, state, and local level.
Is buying a house with student loan debt right for you?
Before you jump in, make sure you’re actually ready to buy a home. Figure out how comfortable you are with carrying two large debts over long periods of time. Do you feel confident about your income? Is it large enough to comfortably afford a mortgage payment on top of your student loan payments?
Review your priorities. Will buying a home on top of having student loans require you to cut back on your retirement contributions? Will you have to dial back in other areas of your life? Consider what matters most to you, and plan accordingly.
If you have a plan for buying a home, there’s nothing wrong with taking the leap even though you have student loan debt.
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