Mortgages, Student Loans, and Homes: It’s Not As Bad As You Think
Given that the Democratic Presidential Debates have begun, and a few potential candidates have made the student debt crisis the cornerstone of their pitch, this article will briefly discuss an issue that is likely on the minds of many Americans: “Can I qualify for a mortgage despite having massive student loans?” Like most things, the answer is “it depends.”
After the “Great Recession”, many Americans were faced with a semi-existential crisis. Without getting into the nuts and bolts of that crisis (nobody really agrees on the nuts and bolts anyways), a massive number of people made the decision to attend (or return to) college or graduate programs to bolster their credentials in the hopes that it would lead to a better paying job (and ostensibly, serve as an escape valve from the woes that were facing the majority of Americans). This, in turn, required most people to obtain student loans (this article is not about how student loans have spiraled out of control, but it is important to note that the amount of the loans have increased significantly). The natural result of taking out student loans, for whatever reason, is to fundamentally alter that person’s debt-to-income ratio (“DTI”); an unfavorable debt-to-income ratio can have a profound impact on your ability to obtain financing for major purchases… like a home. Luckily, the damage to your ability to obtain a loan is vastly overstated.
As an initial matter, DTI comes in two flavors: front-end DTI (also referred to as the “housing ratio”) and back-end DTI; your student loan payments (as opposed to the total amount of your student loans) will impact your back-end DTI, but not your “housing ratio.”
Your housing ratio is a function of your probable mortgage payments (per month) over your gross (before taxes) income (per month). To determine your probable mortgage payments per month, the bank utilizes your “PITI”, which includes the [P]rincipal of your mortgage, [I]nterest payments on your mortgage, [T]axes on your property, and [I]nsurance on your property.
Example: Ben Borrower earns an annual salary of $120,000 (or $10,000 per month, before taxes), and has an annual “PITI” of $48,000 (or $4,000 per month). To discover Ben’s “housing ratio”, we divide Ben’s $4,000 per month “PITI” by Ben’s $10,000 per month income and find that Ben’s “housing ratio” is 40%; this is very bad news for Ben, he would be wise to look for a home where the “PITI” would be between $2,000 and $3,000 (20% -30% “housing ratio”).
Lenders typically set the maximum “housing ratio” limits for a conventional loan of roughly 28% (So Ben is not going to qualify for a conventional loan on this property because he is far over the typical limit). However, Federal Housing Administration loans (“FHA Loans”) allow borrowers to have a “housing ratio” of up to 31% (Ben is still SOL).
Assuming you’re not like Ben and have a “housing ratio” that falls in an acceptable range, lenders will then look at your “back-end DTI”; this takes into account all your debt obligations (including “PITI”, credit card debts, support payments, and those pesky student loans) and its relationship to your gross monthly income.
Example: Ben Borrower still earns an annual salary of $120,000 (or $10,000 per month, before taxes), but is now looking at obtaining a mortgage for a house where the annual “PITI” of $24,000 (or $2,000 per month). Using the process described above, we know that Ben’s “housing ratio” is 20%; Ben is feeling pretty good about this house. However, Ben owes $1,000 per month in support (spousal and child), $200 per month in various credit card bills, and $300 per month in student loan payments (this may be low considering his income of $120,000, but student loan payments do consider other obligations when determining your payments when you are involved in an income-based-repayment plan). To obtain Ben’s back-end DTI, we divide Ben’s total monthly debt obligations [$2,000 “PITI” + $1,000 in support + $200 in credit card bills + $300 in student loan payments ($3,500)] by Ben’s monthly income of $10,000. We discover that Ben’s back-end DTI is 35%; Ben is close, but he might be able to get this house after all.
Conventional loans tend to set the back-end DTI limit at around 36% (Ben just made the cut), but FHA loans allow for a back-end DTI of 43% (In the example above, Ben would qualify for the FHA loan, but he would not qualify if he was still looking for that home where the “PITI” was $4,000 [since his back-end DTI would be 55%]). If you have exceptional credit, there are lenders he will allow a back-end DTI of up to 50% (Sorry Ben), but this is the exception not the rule.
So, what does the responsible, student-debt holding, American do if they want to buy a house; even though their “housing ratio” or their back-end DTI suggests they will never be able to do so?
It’s pretty straight forward – change the equation in your favor (some of this is going to sound a lot like “let them eat cake”, but it should be read as “hold off on pursuing this until you’ve changed those numbers). The first thing you can do to attack your “housing ratio” and back-end DTI head-on is reduce your PITI.
If you recall, the first two portions of “PITI” consist of the [P]rincipal on your mortgage and the [I]nterest on your mortgage. Further, the interest on your mortgage is a direct function of the principal of your mortgage. To attack a major component of “PITI”, you simply have to take a smaller loan. In order to do that, you will have to make a larger down-payment (which assumes you have the liquid assets to do so); this will drastically alter the equations (in your favor).
Alternatively, you could increase your income, but that sounds a lot like Charlie Day’s quote about “going down to the job store” in It’s Always Sunny in Philadelphia. Your best bet is to take the larger down payment route
At the Chernov Team we understand that knowledge is power. Given that a large number of potential home-buyers are saddled with debt from student loans, knowing how to improve your chances of obtaining a loan is powerful knowledge indeed. While the loans certainly make things slightly more complicated, it is not a death sentence. At the Chernov Team we know that whoever comes to the table most prepared leaves with the most, and the Chernov Team always leaves the table with the most.