The CNBC Headline in late June was attention-grabbing: 83% of non-homeowners say student loans are the reason they can’t afford to buy. The story went on to explain this was especially true of millennials, who make up the majority of first-time homebuyers.
Between 2005 and 2014, the homeownership rate of young adults decreased by 9 percentage points. Of the total drop, 2 percentage points was due to increasing student loans, according to a January 2019 report by the Federal Reserve.
“[These 2 percentage points represent] over 400,000 young individuals who would have owned a home in 2014 had it not been for the rise in debt,” the Federal Reserve reported.
The domino effect may increase those numbers. If any of these borrowers miss a payment or default on their loans, it will be even harder for them to get a mortgage in the future.
Here at Own Up, we follow these trends closely. Our business is focused on getting you a better rate on your mortgage. But that is not all. We aim to support homeowners through the entire home buying journey. That includes the time before you buy a house when you are making critical financial decisions. At the top of this list is how you pay back your student loans and what this means for future homeownership.
Our customers save an average of $21,000 over the life of their loan because we use technology to match customers with better mortgage rates. Because Own Up brings customers to lenders with less work, they offer us lower interest rates, and we pass the savings on to you.
5 Things to Know
Total student loan debt is now over $1.5 trillion. The average student loan debt ranges from over $30,000 in the states with the highest average student debt to about $22,000 in the states with the lowest average student debt.
A home used to be the largest financial transaction people would make. Student loan debt is catching up, and in some situations surpassing a mortgage.
If you have student loans, even big ones, don’t despair. Buying a home might still be within reach. It just requires an education in financial risk and the loan landscape so you can plan wisely. Here are some key things to know.
1. Student loans are good for your credit score if you pay them back on time, as they provide a history of responsible payments.
2. There are no second chances! One payment over 30 days late could cause a 90 to 110 point drop in your credit score. A credit score of 700 is good while a score of 600 is only fair. That drop has big implications for getting a mortgage and what rate you are offered.
3. Repayment plans are available for borrowers who can’t afford their loans. While standard federal loans are calculated to be paid off in 10 years, all federal loans offer graduated plans where monthly payments increase over time and extended plans where payments are fixed or graduated. In both of these cases, you will pay more over the term of your loan than under standard repayment, but less each month.
4. The federal government also offers income-based plans that insure your payments are about 10 percent of discretionary income. They do this by extending the loan period, so you usually pay more over time.
5. Lenders look at your debt-to-income ratio when determining whether to offer you a loan. They look for a ratio under 36%. If yours is higher than that due to student loans, you should consider finding ways to cut back your budget and pay down your student loans if you can.
Your Student Loan Payment Options
There are many different options for paying off your student loans, and one is not necessarily better than the other. It comes down to your personal circumstances and goals. If you are looking to become a homeowner, here’s what to know about each option.
1. Student loan consolidation or refinancing lets borrowers roll all of their loans into one. If you have multiple loans and have trouble keeping track of them, which could lead to late payments and a ding to your credit score, this might be the best option for you.
2. Some loan consolidations offer lower monthly payments, but they often do so by extending the overall payment period from the traditional 10 years to up to 25 years. This means you will pay more over time. Choose a plan that lets you pay off your loan as quickly as possible so you can save for a down payment on a house. Or get a lower payment so you can lower your debt to income ratio and increase your mortgage eligibility.
3. Some people struggling to pay their federal student loans turn to income-based plans. These plans calculate monthly payments to be a certain percent of discretionary income, usually 10 percent, and forgive any loans not paid back after 20 or 25 years. Many of these plans are for borrowers with a lot of student loan debt and high debt relative to their income. Borrowers must pay taxes on any loan amounts that are eventually forgiven. These plans are called pay-as-you-earn, revised pay-as-you-earn, income-contingent-repayment, and income-based repayment.
How Mortgage Lenders Calculate the Debt-to-Income Ratio
The debt-to-income ratio (DTI) is derived by dividing your monthly debt by monthly gross income. The resulting ratio tells lenders how well you manage debt.
Lenders use two kinds of ratios:
1) The back-end-ratio. This takes into account daycare, utilities and other revolving debt on your credit report. Lenders prefer no more than 36% for the back-end ratio.
2) The front-end ratio, also called the housing ratio. This ratio looks at housing as a percent of total gross income. Lenders prefer no more than 28% for the front-end ratio.
If you are in the market to buy a house, you might work to pay down your student loans to qualify for a better mortgage. Don’t do this without research. This is a good idea if your loans have variable rate interest or if you would not qualify for any type of forgiveness, such as income based-repayment plans. If your loans have low fixed interest rates or you might qualify for income-based-repayment, paying your student loan debt early is not as beneficial.
Changes by Fannie Mae and Freddie Mac since 2017 mean that borrowers with income-based-repayment plans will have an easier time getting a mortgage. “If the borrower is on an income-driven payment plan, the lender may obtain student loan documentation to verify the actual monthly payment is $0. The lender may then qualify the borrower with a $0 payment,” Fannie Mae explained in a 2019 update. Before 2017, the policy required lenders to use 1% of the outstanding balance, or a calculated amount based on a fully amortized loan when student loan payments show as missing or $0 on a credit report. To use easy numbers, a $100,000 would calculate to $1,000 a month under the 1% rule, a big chunk of monthly expenses. Freddie Mac now uses the monthly amount on the credit report or 0.5% of the original loan balance or outstanding balance (whichever is higher).
Now that Freddie Mac and Fannie Mae have changed their math, reach out to us to examine yours. The relationship between DTI, mortgage rates and savings is a careful individualized balancing act. Consider this: Should you refinance and save 1% on an interest rate for a shorter-term loan? It depends on your goal. If it’s home ownership, maybe not.
Here's the math courtesy of the Student Loan Hero calculator:
- You would pay $7,523 in interest for a $35,000 loan with a 4% interest rate over 10 years. That is $354 a month.
- If you refinanced, you would pay $2734 in interest for a $35,000 loan with a 3% interest rate over 5 years. That is $629 a month.
You spend an extra $275 a month to save $4,789.
Now look at the mortgage side. The higher payments would increase your DTI. What if that caused a 0.25% increase in your mortgage rate? That would cost you about $20,000 over 10 years on your mortgage. Your student-loan savings is a fraction of that.
Education is one step toward the American Dream for many people. By understanding the debt you have taken on and how to best pay it back, you can plan for another big step in that dream: Homeownership. At Own Up, our team of advisors is well versed in all kinds of debt and how to put you in the best position to save the most money and become a homeowner.