How Student Loan Debt Can Affect a Mortgage Application

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Could student loan debt be holding back many Americans from getting approved for a mortgage? For many people, student loan debt is one of the largest outstanding debts they'll ever have besides a mortgage. Even though the payments may be designed to be affordable, the large lump sum can make a potential buyer's creditworthiness seem lower, which is why it can be harder sometimes to get a mortgage when you have student loan debts.

Debt-to-income ratio
An important part of anyone's financial picture as seen by a bank is that person's debt-to-income ratio or DTI. This is the total amount of monthly payment obligations toward debt in relation to a person's income. Lenders use this formula to determine how easily someone can handle a new monthly payment, and for how much, comfortably. Generally, mortgage lenders want to see a DTI of about 36 percent or less, meaning 36 percent of one's income is spent on costs of housing (the projected mortgage payment), car loans, student loans, credit card payments, alimony or child support and any other outstanding debts.

Many students these days can quickly rack up well over $50,000 in student loans, and some graduates carry over $100,000 in debt. Often the student loan amount is divided up across several banking institutions, each with a minimum monthly payment. On a credit report, this amount can really add up and turn a lender off.

Loan consolidation 
Consolidating the outstanding student loan amounts into one loan and one payment can be a good way to lower the total amount of payments. It is important to look closely at the numbers and get several quotes, because interest rates can vary. Loan consolidation could lower the monthly payment amount, but, if the interest rate is high, the move could prove costly over time.However, if making the change improves the DTI significantly enough to be approved for a mortgage, the loan could possibly be refinanced with a low-interest rate home equity loan down the road.

If the student loan debt is currently under deferral, a lender is likely to use a flat rate of 2 percent of the outstanding loan principle to calculate the monthly payment, so, even if the payment isn't part of the monthly budget now, the lender will consider it to be.

Pay down the debt 
If an immediate consolidation doesn't lower the DTI, then a strategy to reduce the debt should be the next part of the plan to purchase a home. Work with the lending institution(s) to see how much the debt can be reduced by increasing the monthly payments over a period of time. Figure out when the debt will be low enough to consolidate for lower payments, or pick one of the smaller loans to eliminate with extra payments if possible. By developing a game plan to reduce the amount of the loan by making higher or extra payments, the result will not only be a lower DTI after consolidation but also proof to the lender that the buyer can afford to pay more.

Reducing student loan debt at a faster rate than planned is only a good idea if there aren't any significant debts—like credit card amounts, which carry high interest rates. Debt that is accumulating higher interest or other fees should be the first to be wiped out by the future homeowner.

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