A good debt ratio is the key to qualifying for a mortgage. Every monthly debt you have increases this ratio. You might not know that even loans that are not currently due affect your debt ratio as well. This includes deferred student debt. Even if you have several years before your loans are due and payable, they affect your debt ratio.
Why would a lender care about a debt you don’t have to pay right now? They need to minimize their losses. If you have additional monthly debts in the next few years it could make it harder to make your mortgage payment. A mortgage lender needs to think about the risk of default. The good news is that the Federal Housing Administration recently reduced the required calculation for deferred debts.
What is Deferred Student Debt?
Not every student qualifies for a deferred loan, but if you do they can help. Deferred student debt is a loan you do not have to pay right now for one reason or another. Common reasons include current enrollment in school; serving in the military; unemployment; and other economic hardships. This does not mean the loan goes away, though. The debt remains in your name; you simply receive an extension to start your payments. The debt still shows up on your credit report.
How Is Deferred Student Debt Calculated?
If you don’t owe payments right now, how does the FHA calculate your debt ratio? They have to include the debt, but without a payment reporting on your credit report, the FHA has to calculate their own payment. Before late last year, that amount was 2% of the loan amount. So let’s say you had student loans of $40,000 outstanding. The lender would use a monthly payment of $800 for your debt ratio. That is a huge number and one that could easily render you ineligible for a mortgage.
Today, however, the FHA only uses 1% of the balance you owe as your payment. That same $40,000 debt now only has a $400 payment included in the debt ratio. This can make a significant difference in your debt ratio calculations, especially if you are close to the maximum amount allowed. Because the FHA allows more flexibility with debt ratios, this could have significant impact on the ability for many borrowers to obtain a mortgage.
The Two Debt Ratios
There are two debt ratios you need to worry about – the front end and back end ratio. The front end ratio is strictly the mortgage payment and the amount of your monthly gross income it encompasses. The mortgage payment means your principal, interest, taxes, and insurance.
The back end ratio is the total monthly debts. This means your minimum credit card payments, car payments, student loan debt plus your total mortgage payment. In general, the front end ratio should be around 31 percent and the back end around 43 percent. As stated before, though, the FHA does allow more flexibility for borrowers who might be close to these ratios but slightly over. As long as you have other compensating factors to make up for the higher level of risk, an FHA loan is often an option. These compensating factors include stable income, high credit scores, and adequate monthly reserves.
How Deferred Student Debt Figures Into Your Debt Ratio
The lender figures your deferred student debt into your back end ratio. Now that the amount lenders must use 1% of the loan amount, it gives some borrowers more purchasing power. For other borrowers, it is the difference between a loan approval and a denial. Keep in mind, however, if the lender holding your student loan reports a minimum payment on your credit report, the mortgage lender must use that number for qualification purposes.
If you do not agree with the amount reporting on your credit report, you would have to obtain proof from the lender holding your student debt of the lower minimum payment. You can also provide the loan papers from your student loan if a different payment reports on the papers you signed.
Should You Rely on the Debt Ratio?
Many people assume if they qualify for a specific loan amount that they should take it. This is not the case. What you qualify for on paper is not necessarily what you can comfortably afford in real life. Set a budget and figure out how your mortgage payment will figure into it. Don’t forget to take into consideration the upcoming deferred student debt payment. Even if your loan is deferred for several years, it will still become due eventually. The last thing you want to do is overwhelm yourself with payments you cannot afford. A student loan debt might not leave you without a home, but a mortgage you default on definitely would leave you homeless.
The changes the FHA made regarding the calculation of deferred student debt is a positive change as it helps many more people secure a mortgage. However, you should still use your own judgement based on the money you bring into your home every month. If you are unsure about the amount of a payment, talk to your lender about your options. Sometimes securing a lower interest rate or searching for a less expensive house is necessary to help you keep your mortgage affordable. Remember, this is one of the largest investments of your life, so you should enter into it very carefully.
