With May upon us, another school year is drawing to a close. As the class of 2018 gets ready to graduate and start their lives and careers—with their student loans in tow, it seems like a good time to discuss the impact student loans have on qualifying for a mortgage.
The amount of outstanding student loan debt is pretty staggering — $1.3 trillion (trillion… as in 12 zeros!). 37% of people under age 30 and 22% of people from 30-44 carry student loan debt. The average amount of student loan debt someone in the class of 2017 is $17,000, but a quarter of grads owed $43,000 or more. (Source, Pew Research Center.) As you can imagine, we work through student loan matters on a regular basis as we qualify our clients for loans.
A simple equation that looms large
The way lenders determine the amount you qualify to borrow is by doing a little quick, simple math. We figure a ratio of your debt to your income. This is your “debt-to-income ratio” or DTI. (We’re creative with our names, aren’t we?) We figure two debt-to-income ratios on every loan: “front” and “back”.
The front DTI starts with your proposed house payment, including the loan, taxes, insurance, mortgage insurance and HOA dues. We call this total monthly payment “PITI” (short for principal, interest, taxes, insurance). To figure your front DTI, we divide your PITI by your pre-tax monthly income.
PITI divided by pre-tax income = Front DTI
The back DTI is figured by adding, to your PITI, all of your other monthly payments for consumer debt, including credit cards, car payments and student loans and then dividing this total by your gross monthly income.
PITI + other monthly minimum payments divided by pre-tax income = Back DTI
There are some circumstances under which the front DTI comes into play, but generally speaking it is the back DTI that matters–including any student loan payments.
Student loans = agents of chaos
Things get a bit weird for lenders when it comes to student loans. We calculate a debt-to-income ratio in order to predict a prospective borrower’s ability to repay their loan. With this goal in mind, the underwriter is looking for a stable monthly income and stable debts.
But unlike almost any other kind of debt, student loans allow borrowers to choose from a menu of repayment plans. The monthly payment due on a given loan can vary significantly from one plan to another and change from year-to-year. The result is that student loans turn the DTI into a moving target. Lender’s like stability and predictability, not moving targets.
A myriad of repayment options
Repayment plans for student loans include Standard repayment plans, Graduated repayment plans, Extended repayment plans, Pay As You Earn repayment plans, Revised Pay as You Earn repayment plans, Income Based repayment plans, Income Contingent repayment plans, and Income Sensitive repayment plans. There are even programs under which teachers and other employees of government and not-for-profit entities can have their student loans forgiven over time. You get the idea… there are lots of payment plans.
And sometimes no payment whatsoever is required. This is the case for loans in deferral or forbearance, but can also be the case for loans that are actually in repayment. If the formula used to calculate the required payment yields zero, then that’s the payment due — $0 each month.
Creating order from chaos
Different loan programs deal with the wild variety and instability student loan payments bring to the lending picture in different ways, but every program has a rule for what monthly payment we are required to use when calculating a DTI.
Here is where things currently stand:
Squint at that chart a minute and you’ll see “greater of” listed a number of times. Wherever you see that, a borrower’s debt-to-income ratio is figured using a “phantom” monthly payment they don’t actually make. These phantom payments can make a big difference in the amount a person can qualify to borrow. Keep reading for an example.
Special loans for physicians, dentists and veterinarians
Another thing that may have caught your eye: there are special loans designed just for doctors. Depending on the specific loan program, these are open (variously) to physicians (MDs and DOs), dentists, orthodontists… and even veterinarians. There are lots of cool features built into these loans (such as the option to put as little as 5% own and pay no mortgage insurance). All of the doctor’s programs that we offer allow us to exclude student loans from the DTI when the loan will be in deferral for at least a year after the closing date. And student loans are commonly deferred during a newly minted doctor’s internship, fellowship and residency.
Rule of thumb to use and remember
With rates hovering in the mid-4’s today, every $1000 of loan (on a 30 year fixed rate) equates to about $5 of monthly payment. I could write a whole post on the many ways in which this rule of thumb comes in handy. As it pertains to student loans: every $5 per month of student loan payment “takes away” a $1000 of borrowing power.
A real world example
So how does this play out in the real world? Let’s say you have $75,000 of student loan debt. You’re on an Income Based Repayment plan and pay $250 per month on your loan.
Fannie Mae and the VA will let us use the actual $250 payment in your DTI. Freddie Mac will require that we use $375 (.05% of balance). FHA will require that we use $750 (1% of the balance). The worst case on a jumbo loan would be as much as $938.
Here’s where that rule of thumb comes in handy:
• The $125 per month of phantom payment Freddie Mac requires (the difference between the actual payment and the “qualifying payment”), divided by $5.5, takes away $25,000 higher of the buying power you would have with Fannie Mae.
• The $500 per month of phantom payment FHA requires, again divided by $5, takes away $100,000 of your buying power relative to Fannie Mae.
• And the $688 per month higher payment on a worst-case jumbo loan, equates to a $138,000 reduction in your buying power relative to another jumbo program that would allow us to qualify you using your actual monthly payment.
That’s a pretty significant difference!
Everything here is, to the best of my knowledge, accurate as of today (May 2018), but is subject to change. Of course, all loan guidelines are always subject to change, but student loan rules have changed quite a bit in recent years.
Get pre-approved before you shop
If you’re thinking about a home purchase and are carrying student loan debt, your first step should be to reach out to your chosen lender, discuss the loan options that fit your goals and make sure you understand how your student loans impact the amount you can qualify to borrow.
After doing so, you can house-hunt with confidence and a pre-approval letter to show the seller of your dream home.
If you have any questions on this topic or would like to start the ball rolling on a pre-approval for your own house-hunt, please email or call any time. My team and I are at your service and look forward to hearing from you!
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