Question: We went to see a mortgage lender. We were doing great until the conversation turned to student loans. We have $28,000 in remaining student debt but are not paying anything right now.
The lender wants to add $280 our monthly debts for the student loans and that means we either don’t qualify for a mortgage or can only borrow less. What can we do?
Answer: Student debt has become a financial curse for many potential home buyers. Last year, the National Association of Realtors estimated that the typical first-time buyer was saddled with $29,000 in student debt while the Consumer Federation of America put the figure at $30,650. The Federal Reserve Bank of New York says student debt at the end of 2017 amounted to $1.38 trillion. That’s up from $550 billion ten years earlier.
Vast amounts of student debt are a problem for lenders and therefore a problem also for borrowers. Lender guidelines – the debt-to-income ratio or DTI — limit the amount of monthly income that can be used for recurring debts.
For instance, if your household income is $7,500 a month and lenders allow 43 percent for debts then you can spend $3,225 for such costs as credit card bills, auto payments, student debt, and housing expenses.
In the case of student debt, lenders can look at the actual monthly payments to figure the DTI ratio. However, the way student loans are set up there are often lengthy periods when payments are not being made. This is not because the loans are in default but because federal borrowers are allowed defer payments, perhaps because of active status as a student.
With a “deferment,” student loan borrowers may be able to avoid interest costs; however, another way to skip monthly payments is with “forbearance.” With forbearance, you are not required to make payments but interest on the debt continues and is added to the amount you owe.
To make the student debt system even more confusing, it’s entirely possible to have debt which you don’t actually have to repay. In such cases, you have to wonder if that student debt is really debt or just an oddball accounting blip.
According to the Department of Education “’loan forgiveness’ is usually used in reference to the Direct Loan and FFEL Teacher Loan Forgiveness Program or the Direct Loan Public Service Loan Forgiveness Program. Borrowers are not required to pay income tax on loan amounts that are canceled or forgiven based on qualifying employment.”
To lenders student loans show up as “debt” and debt is something that has to be considered when figuring the debt-to-income ratio. How the debt is figured can vary.
One approach is to simply look at the payments actually being made and have them count in the DTI ratio.
If payments are not being made then lenders might calculate an “imputed” monthly cost equal to 1 percent of the student loan balance. This can be brutal for people with advanced degrees who have six-figure student debt balances.
What can you do if you have large amounts of student debt? How can you improve your DTI situation?
First, you can pay down student debt. This sounds good in theory but in practice, this may not be the best debt to pay down if it makes little difference in your monthly costs.
Second, look for relief elsewhere in the DTI calculation. For example, paying down high-cost credit card debt results in an instant reduction in required monthly payments.
Third, borrow less. Housing costs are included in the DTI calculation. If you apply for a smaller mortgage the monthly cost will be lower and will have less impact on the debt-to-income ratio.
Fourth, finance with an ARM. ARM start rates are lower than fixed-rate financing so the monthly cost is smaller and that’s good for the DTI. Look at 5/1, 7/1, and 10/1 ARMs.
For specifics go over your numbers with a mortgage loan officer and see what strategy is best for you.