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Three ways to tame student loan debt and afford a mortgage

It’s no secret that student loans can make buying a home a challenge. But what exactly is the problem, and how can buyers overcome it?

The problem is that student loans can be included in the buyer’s debt-to-income ratio.

What is debt-to-income ratio?

The debt-to-income ratio is the percentage of monthly income that is spent on debt payments, including mortgages, student loans, auto loans, minimum credit card payments and child support.

Debt payments/income

Example: Jessie and Pat together earn $5,000 a month. Their total debt payments are $1,600 a month. Their debt-to-income ratio is 32 percent ($1,600 divided by $5,000).

This ratio is one factor lenders use to decide whether a buyer can afford a mortgage payment. Generally, mortgage lenders prefer a debt-to-income ratio of 36 percent or less. In some situations, lenders will approve mortgages with debt-to-income ratios up to 43 percent or even higher.

Hard to nail down

The house payment is an important part of debt-to-income ratio. Because the house payment is affected by house price, property taxes and interest rate, a borrower’s ratio is a moving target.

“The misconception is that there is a magical dollar amount that somebody will be qualified for, and that’s not the case,” says Jay Dacey, a mortgage broker at Metropolitan Financial Mortgage Co. in Minneapolis. “What the banks actually underwrite to is what the monthly payment is.”

Ratio and student loans

Whether student loans are included in debt-to-income ratio depends on the type of loan and whether the payments are current or have been deferred.

If the buyer applies for a conventional mortgage or VA loan, guaranteed by the U.S. Department of Veterans Affairs, any student loans will be included, even if the payments have been deferred, said David Krichmar, a mortgage banker at Core Lending in Conroe, Texas.

If the buyer applies for an FHA loan, insured by the Federal Housing Administration, any student loans will be included unless the payments have been deferred for at least 12 months. In that case, the payments can be excluded from the debt-to-income ratio.

Fixing the problem

There are three ways to overcome a debt-to-income ratio difficulty: Reduce debt, increase income or decrease the target mortgage payment.

Reduce debt

Some lenders will remove an installment or closed-end loan, such as a car payment, from the debt-to-income ratio if the loan will be paid off within 10 or fewer payments. Dacey says if a buyer pays off enough of a loan to reduce the balance to 10 or fewer payments, the debt-to-income ratio can benefit.

Reducing or paying off credit card debt can help, too, although the 10-month rule doesn’t apply because a credit card is revolving or open-ended debt.

Another improvement strategy is to pay off the student loans with a private loan, perhaps from a family member, at a lower interest rate or with a longer repayment term. The private loan must be disclosed to the lender.

Moving debt around

Buyers who are married and don’t live in a community property state might be able to reconfigure the income and liabilities to overcome a debt-to-income ratio hurdle.

“Let’s say the husband stays home with the kids and (the couple) has a joint auto loan that is truly the dad’s truck. I’ve seen people refinance out of their existing auto loan and put it into the (name of the) spouse who doesn’t have the income,” Dacey says.

The income-earning spouse then applies for a mortgage without the debt-burdened spouse.

Increase income

The rule of thumb is that income must be documented for two years to be included in debt-to-income ratio. But Krichmar says a buyer’s college history can make up almost all of that two-year time frame, and a new job in the same field isn’t necessarily a negative, especially if it comes with a higher salary.

“That income could be used to qualify as soon as you have 30 days of pay stubs,” he says.

Different rules apply to commissions, bonuses, self-employment income and hobby businesses.

Decrease mortgage payment

It may seem counterintuitive, but buying a house instead of a condominium can improve a buyer’s debt-to-income ratio because homeowners association dues are included in a condo payment but not a house payment.

“Somebody might qualify to buy a $150,000 house but not a $150,000 condo because the association fees might be a little bit too high,” Dacey says.

Buying a home in an area with lower property taxes or paying an upfront fee to decrease the mortgage interest rate also could help. The upfront fee is known as discount points or a buy-down.

It’s tough out there

Only 33 percent of 2015 homebuyers were first-time purchasers, according to a survey released by the National Association of Realtors. That was the lowest proportion since 1987, excluding 2014, when the proportion was also 33 percent.

What’s more, 22 percent of millennial buyers said saving for a down payment was difficult, and 54 percent of that group cited — you guessed it — student loans as a factor.

Real estate brokers are concerned about this issue, says Wendy English, sales manager at Century 21 Commonwealth in Medfield, Massachusetts.

“Setting aside for the down payment and closing costs is difficult because their money is going toward living expenses and paying student loan debt,” English says. “They might want to buy, but they have that burden of the student loans.”

12,563 rubber duckies

One way to understand the impact is to try the make-your-own-infographic function at the website of the Young Invincibles, an advocacy organization in Washington, D.C.

Plug in, say, $25,000 of student loan debt, and you will discover that’s equivalent to about 60 percent of the average down payment to buy a home. It’s also equal to about 2.4 years of average rent payments, 676 toaster ovens or 12,563 rubber duckies.

Student loans are a significant factor for many young adults in their prime first-time homebuying years.

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