With more people making monthly payments on record levels of student loan debt nationwide (surpassing money owed on credit cards), it’s not surprising that buying a home for many seems a stretch too far.
Prospective homeowners generally need a down payment of 20% to get a conventional loan to pay for a mortgage. If it’s less than this, mortgage insurance becomes a necessity, adding between 0.3% and 1.5% to the total cost of the loan.
With Federal Housing Administration (FHA) loans, you only need to make a down payment of 3.5%. Still, this type of loan usually is accompanied by a higher interest rate and typically requires mortgage insurance. Once your home equity reaches 22%, you can dispense the mortgage insurance.
Today, over two-thirds of college graduates are saddled with student loan debt. This is compared to under 50% in the early 1990s. In those days, the average student loan balance was $9,000. Now, student loan debt averages around $30,000, with a typical monthly payment of about $400 – which can be particularly difficult to bear when starting in the workforce, usually with a modest salary.
At the same time, homeownership rates among young people are falling. According to the Federal Reserve, for every 10% in student loan debt, a person’s chances of owning a home drops 1 to 2 percentage points during their first five years after graduating. The National Association of Realtors claims that over 80% of people aged 22 to 35 haven’t bought a house because of student loan debt.
The good news is that you can have student loan debt and qualify for a mortgage to buy a home. A student loan is just part of a larger financial picture that is used by lenders to determine eligibility.
The Case for Saving for a Down Payment
Many people believe it is an either/or situation when it comes to saving for a down payment or paying off student debt. The case for saving to buy a home includes:
- You often pay more in the long run when renting.
- Housing and interest rates may continue to rise, so buy now while you still can.
- Buying a home is a good investment since prices have risen an average of 6.5% since 2015.
- Student loans usually have low interest rates and are tax-deductible (up to $2,500 per year), so it makes more sense to put money toward a down payment, which lowers the overall cost of owning a home.
The Case for Paying Off Student Loans
The reasons some people decide to pay off student loans instead of investing in a home include:
- There is a psychological effect that often comes with buying a home while still in debt. Graduates may want to buy a house only when they are debt-free.
- The longer it takes to pay off student debt, the more interest that is paid over the life of the loan.
- If the student loan rate is variable, it will likely go up over time.
- Once the student loan is paid, the debt is erased from a person’s credit report, giving a small bump to their score.
Cope With Student Debt and Buy a Home
As pointed out, student loan debt is only part of a person’s overall financial picture. How they manage the different pieces of their larger financial situation will determine whether they can realize the elusive dream of homeownership and managing debt.
While it will take some hard work, here are strategies to help you achieve both.
Get the Big Picture
When people get into debt, they often bury their heads in the sand to avoid the stress of dealing with the situation. The first step in remedying this is to look at your big debt picture, compiling all debts, including student and car loans, money owed on credit cards, and so on. The picture should include the principal (balance owed), interest rate, and monthly payment amount for each loan or debt.
Pay Off High-Interest Loans First
You should strive to pay off the student loans with the highest interest rates first. When one is paid off, move to the next highest one. This approach will save you money in the long run.
Manage Your Debt-to-Income Ratio
When it comes to eligibility for home and other kinds of loans, and the interest rates offered, most lenders evaluate applicants’ debt-to-income ratio. This is a person’s total monthly debt payments compared to their monthly income. Lenders use this to determine if an applicant has enough money to cover living expenses after paying off their debts and the room in their finances to take on additional debt (the home loan).
Managing your debt-to-income ratio is a two-prong strategy: A person can pay off debt or earn more income (if that’s the case, it might be time for a side hustle) – and in a perfect world, they would do both.
Boost Your Credit Score
Your credit score plays a big role in telling potential lenders how risky you are for a home loan. Score providers, such as the three nationwide credit bureaus – Equifax, Experian, and TransUnion – and companies like FICO use different types of credit scoring models.
Generally speaking, the higher score, the better the credit rating. With the often-used FICO range, 350 to 850, a score of 750 or higher is considered a good risk, and 600 and lower a bad one. It’s worth checking your credit report from the major credit bureaus to see where you stand, what you need to work on, and to correct any errors that might be damaging your score.
Some ways to boost your credit score include:
- Paying debts, including student loans, on time.
- Lowering your credit utilization rate (this accounts for 30% of your credit score).
- Not applying for new credit cards, loans, and lines of credit.
- Not closing paid-off accounts since the length of credit history is also important.
Avoid Using Deferment or Forbearance
If you are having trouble paying your student loans, you could qualify for deferment or forbearance, temporarily suspending payments. While this may help by providing short-time relief, interest will continue to accrue, meaning that you will pay more for the student loan over its life. If you take advantage of either of these in the run-up to applying for a home loan, it could signal to lenders that you are having financial difficulties.
If you have different debts, including student loans, then consider getting a consolidation loan, which may result in a single, lower payment overall.
A personal loan also can improve your credit score because it is an installment loan with a fixed repayment term. Credit cards, in contrast, are revolving loans and with no fixed repayment terms. So, if you exchange credit card debt for a personal loan, you can lower your credit utilization and diversify your debt.
Refinance Student Loans
It may be worth considering refinancing student loans, perhaps achieving a lower interest rate and a better debt-to-income ratio, and signaling to potential lenders that you are in a stronger position to handle the debt.
There are student loan refinance lenders who offer lower interest rates, so it is worth shopping around. Each lender has eligibility requirements, which may include a borrower’s credit profile, minimum income, debt-to-income ratio, and monthly cash flow.
Get Down Payment Assistance
If student loans make it difficult for you to save for a home down payment, you don’t have to give up hope. There are various types of down payment assistance programs available, including federal, state, and local.
- FHA loans: Loans made through the Federal Housing Authority
- USDA loans: Zero-down mortgages for rural and suburban homeowners
- VA loans: Available to members of the military
Assistance can also come in:
- Down-payment grants: These are free and don’t need to be repaid.
- Forgivable second mortgages: Second mortgages are forgiven if you live in your house for a certain number of years.
- Traditional second mortgages: You receive assistance through low-interest loans, which need to be paid monthly, just like first mortgages.
- Matched savings programs: As you save money in a dedicated down-payment savings account, the institution or agency offering the program matches the funds up to a certain point.
Get the Advice You Need
If you want to know more about how to deal with student loan debt effectively, so you can make major purchases like a family home, check out the resources at CollegeFinance.com – your home for all the planning, borrowing, and payment information you need to make informed decisions about getting a college education and starting the best life after.