For would-be homebuyers with student loan debt, FHA-backed mortgages can be a welcome shortcut to achieving the dream of homeownership.
That’s because FHA lenders don’t require you to save up to make a big down payment. FHA loans are available to borrowers putting down as little as 3.5 percent of a home’s purchase price, compared to the 20 percent you’d need to take out a conventional mortgage without private mortgage insurance.
Now there’s good news for student loan borrowers who are looking to become homeowners. The Department of Housing and Urban Development (HUD) has backed off on rules introduced last year that made it difficult for many borrowers with deferred student loans to qualify for an FHA-backed mortgage.
It used to be that if you had deferred student loan debt, FHA lenders didn’t have to take that into account when calculating your debt-to-income ratio (DTI). In the fall of 2015, HUD decided that if a would-be homebuyer’s student loans were in deferment, FHA lenders would still have calculate DTI as if they were making monthly payments on that debt equal to 2 percent of the outstanding balance.
In other words, if you had $25,000 in deferred student loans, an FHA lender would have to assume you were paying $500 a month to retire that debt when calculating your DTI — even if you were paying nothing.
In most cases, FHA-backed mortgages are off limits for borrowers with DTIs exceeding 43 percent. Adding $500 a month to the debt side of the equation — roughly the equivalent of the average new car payment — would be enough to disqualify many borrowers from qualifying for a mortgage (for more on the impact that student loan debt can have on your debt-to-income ratio, see “How student loan debt can get you off on the wrong foot.”)
FHA’s new rules for student loans
In recognition of the fact that the 2015 rule change on deferred student loan debt was causing problems for young borrowers, HUD has revised the formula, cutting the assumed monthly payment on deferred student loans by half.
If you’ve got student loans in deferment, the new rule allows FHA lenders to assume that you’re paying 1 percent of the balance each month for the purposes of calculating DTI. So if you have $25,000 in deferred student loans, an FHA lender will add $250 to your assumed monthly debt obligations, instead of $500 under the old rule.
For many borrowers, the change will be enough to move them from the “Your mortgage application has been denied” category to, “Congratulations, here are the keys to your new home.”
Regardless of the payment status of your student loans, the new rules require FHA lenders to calculate DTI using one of the following amounts, whichever is greatest:
- 1 percent of the outstanding balance on the loan
- The monthly payment reported on your credit report
- The actual documented payment, if that payment will fully pay the loan off over its term
(For all the fine print on the new rules, see HUD’s April 13, 2016 letter to FHA lenders).
The rule change could make it harder to qualify for borrowers who are paying down five-figure student loan debt in an extended or income-driven repayment plan to qualify for an FHA mortgage. That’s because the monthly payment in such plans may be less than 1 percent of the outstanding loan balance.
A borrower paying down $40,000 in student loan debt in a 25-year extended repayment program would have a monthly payment of about $218 a month. But under the new rule, FHA lenders will have to assume their monthly obligation is $400 a month.
For more on how to qualify for a mortgage if you’re enrolled in an income-driven repayment plan, see, “How the government’s student loan repayment programs can trip up homebuyers.”
Watch your debt-to-income ratio
Whether or not it’s wise for someone carrying five-figure student loan debt to take on additional obligations depends on the borrower.
A recent analysis of Credible user data found that a $1,344 monthly mortgage payment could add 9.5 percentage points to the DTI of a borrower holding a graduate degree in medicine, compared to 40.3 percent for a borrower with an undergraduate psychology degree.
The National Foundation for Credit Counseling advises consumers to shoot for a DTI of 36 percent or lower — and that “lower is always better.”
Keep in mind that FHA loans carry insurance premiums. You’ll pay an “upfront mortgage insurance premium” equal to 1.75 percent of your base mortgage amount, and 0.80 to 1.05 percent a year in annual insurance premiums until you pay off or refinance your loan. Although the premiums aren’t a huge burden because they’re incorporated into your monthly mortgage payments, that’s money out of your pocket that you wouldn’t pay if you were putting 20 percent down.
Loans guaranteed by Fannie Mae and Freddie Mac will have the same issue. If you’re making a down payment less than 20 percent, Fannie and Freddie typically require private mortgage insurance. Although HUD slashed FHA annual premiums last year, borrowers with good credit may find that private mortgage insurance is cheaper.
Even though many are loaded down with student loan debt, millennials aren’t letting that stop them from buying homes. Many states have special programs that can help you realize your dream of homeownership — some are targeted specifically at student loan borrowers (for more on how to find programs in your area, see “These states help student loan borrowers become homeowners“).
Qualify for a mortgage by refinancing student loan debt
One way to lower the DTI associated with your monthly student loan payments is to extend your loan term, either by enrolling in a government program or refinancing with a private lender.
Federal student loans are eligible for income-driven repayment plans that can stretch loan terms out to 20 or 25 years. If you’re not reducing your interest rate, stretching out your loan term can also increase the total interest you’ll pay over the life of your loans.
Many borrowers can qualify to lower the rate on their student loans is by refinancing with a private lender. Lenders competing to refinance student loans through Credible platform. Borrowers with good credit and selecting loans with shorter repayment terms will get the best offers.
Borrowers who have used Credible to refinance into a loan with a longer loan repayment term have secured rate reductions averaging 1.36 percentage points, and reduced their student loan payments by $218 a month. If you can prequalify for a $300,000 home loan and then trim $218 off your monthly student loan payment, you’ll boost your mortgage borrowing limit to around $350,000.
Keep in mind that if you refinance federal student loan debt with a private lender, you’ll lose some borrower benefits like loan forgiveness and access to income-driven repayment programs. Do your research.
Credible is a multi-lender marketplace that allows borrowers to request competitive loan offers from vetted lenders, without affecting their credit scores.