Every year, student loans help millions of people invest in a quality higher education. Without these loans, many would be unable to fulfill their dreams and pursue their interests. Although these loans offer great opportunities to many students, they can also block students from future opportunities, inflicting heavy debts over the long term. For example, student loan debt could prevent you from being able to afford something like a mortgage. Although student loans do not outright prevent you from receiving financing on a home, they can make it difficult for you to do so.
Student Loans and Debt-to-Income Ratio
When it comes to buying a home, your debt to income ratio (DTI) plays a huge role in whether or not you qualify for a mortgage. It is a pretty simple concept: DTI is the percentage of monthly income that you put towards paying off any debts, whether it is car payments, insurance premiums, taxes, or student loan payments. This percentage is calculated as monthly debts/monthly income. When applying for a mortgage, if your DTI is greater than 45%, a lender may avoid offering you a mortgage loan because your DTI makes you a risky customer. In order to improve (and decrease) your DTI, you must first understand both sides of it: Front-End DTI and Back-End DTI
Front-End Debt to Income Ratio
Your front-end debt to income ratio can best be defined as housing expenses divided by gross income. Housing expenses includes your PITI (costs of principal, taxes, insurance, and interest payments). If you have a high Front-End DTI, lenders may associate your mortgage application with less risk. The higher this ratio, the more likely you will be able to receive a conventional mortgage.
Back-End Debt to Income Ratio
The back-end debt to income ratio is defined as total monthly debt expenses divided by gross monthly income. This is where student loan debt is factored in. This ratio signals how much of your monthly income goes towards your debts, like student loans. Lenders use this to see how much risk is associated with providing you a loan. If a majority of your monthly income goes towards your debt, you may be considered a high risk borrower.
How to Improve your Debt to Income Ratio
Having a large debt to income ratio could limit your ability to make financial decisions, keeping you from qualifying for a conventional mortgage and other opportunities. If you’re struggling with a high DTI, here are many ways to improve this ratio:
- Start early: One thing we all tend to suffer from is procrastination. When trying to cut down your debt to buy a home, it’s best to start early. If you know that you’re planning to buy a home in the future, prepare yourself by working towards your debt a year or two in advance. This way, you can plan ahead and budget your expenses accordingly, reducing stress along the way.
- Reduce your living expenses: In order to pay off your debts and be able to buy a new home, you need to have a hefty amount of money saved. Consider selling items online that you don’t need or rarely use. Or, more importantly, cut back on spending (which is arguably more effective and lasting). Go out to dinner less, avoid extravagant vacations, and definitely don’t splurge on shopping sprees, online or otherwise.
- Look for ways to earn extra income: Pick up a second job, start a side business, or make good investments in order to establish multiple cash flows. By doing this, you’ll rake in more money and in more than one way, so you aren’t only relying on your primary job for a steady income. If you get laid off or have your salary cut, you will not be too financially rocked and will get back on your feet fairly quickly.
- Decrease your mortgage payment: Instead of having large mortgage payments, it may make more sense for you to look into making smaller payments over a longer period of time. For an example, if you are currently looking into a 15 year mortgage try a 30 year mortgage instead. This will allow you to reduce your monthly mortgage payments and better manage your finances.
- Pay off your student loans: Are you only making the minimum payments on your student loan debt? It may be in your best interest to direct your focus towards paying off this debt and wait before purchasing a home. Although it may be frustrating to put off your financial plans, reducing your student loan debt can open more doors for you in the future, like lower interest rates or a larger loan all together.
Qualifying for a conventional mortgage can be tricky when you have student loans. Here we have shown that there are multiple ways for you to reduce your monthly debt without having to pay off your student loans beforehand. However, be aware that if your back-end ratio is comprised mostly of student debt, it may be in your best interest to wait and pay this debt off.