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Smart financial metrics are often about taking advantage of opportunities as they arise.
Therefore, with interest rates lower than they have been for years, many consumers are looking to to buy a house or refinance their student loans. So if you’re a potential buyer and a student borrower, is there a reason you can’t do both?
As with most questions like this, the answer depends on your personal situation. This is when it makes sense to buy a home and refinance your student loans at the same time and when it is not worth the risk.
How student loans affect your ability to buy a home
When you have a student loan balance, it can affect your debt to income ratio (DTI), which is one of the most important factors considered by lenders. DTI is your monthly debt payments, including your future mortgage payments, divided by your gross monthly income.
Borrowers with a low DTI receive better interest rates and are more likely to be approved, while those with a high DTI may be denied or charged a higher interest rate.
Conventional lenders typically allow a maximum DTI of 36%, while lenders who provide Federal Housing Administration (FHA) or Veterans Administration Loans (VA) will allow a DTI as high as 43%. US Department of Agriculture Lenders (USDA) have a maximum DTI of 41%.
Have a high monthly payment student loan the payment will contribute to your DTI and help determine the mortgage amount for which you are eligible.
For example, let’s say your gross income is $ 4,000 per month. You decide to use an FHA lender, so your maximum DTI is 43%, or $ 1,720 per month. Your student loan payments are $ 1,000 per month, so you are only eligible for a monthly mortgage payment of $ 720.
If the homes you are interested in have mortgage payments that exceed this number, your only options would be to reduce your housing budget or decrease your monthly student loan payment by refinance your student loans.
Benefits of refinancing your student loans
There are many reasons why refinancing student loans before buying a home makes sense.
Refinancing Can Lower Your DTI
Refinancing your student loans can lower your DTI and help you qualify for a mortgage.
For example, let’s say your monthly gross income is $ 3,000. You choose an FHA lender, who sets your maximum DTI at 43%, or $ 1,290 per month. Your current student loan payment is $ 500 per month over a 10-year period repayment plan. You decide to refinance your student loans and end up reducing your monthly payment to $ 300. This frees up more money and means you are now eligible for a larger mortgage than if you hadn’t refinanced your student loans.
Help you save for a down payment
Having a lower monthly payment on your student loans will also help you after you buy the home, as you’ll have more money to cover any home repair or renovation projects.
Disadvantages of refinancing your student loans
There are also some drawbacks to refinancing your student loans. Here’s what you need to know.
It could hurt your credit score
Casey Fleming, a mortgage consultant based in San Jose, Calif. And author of “The Loan Guide: How to Get the Best Possible Mortgage,” explains that refinancing your student loans can lower your credit score. This is because lenders make a firm credit check to assess your credit and determine your eligibility and interest rate. Fleming says it could take several months to bounce back from the lost points after a full investigation. It takes two years for a serious investigation to fall on your credit report.
You can still be approved for a mortgage, but in return you will receive a higher interest rate because of the lower score. Lenders determine the interest rate in part based on your credit score, so a lower score could result in a higher rate.
Because everyone’s finances are different, Fleming recommends that you speak to a loan officer about your particular situation to find out if refinancing will hurt or help you. Examine your credit score before contacting someone, as they will need this information to answer all of your questions.
You can check your credit score for free on various personal finance websites, and many banks and credit card providers also allow you to check your credit score for free, including American Express, Capital One, Chase, and Discover.
You will lose federal loan protections
Refinancing federal loans can lower your DTI and increase the chances of getting a mortgage, but it could leave you with other problems.
When you refinance federal student loans, they turn into private loans. This means that you are forfeiting valuable federal loan benefits like adjournment, abstention and income-based reimbursement option. While some private loans have deferral and forbearance programs, the schedule is never as generous as what the federal government is offering.
These benefits can help you if you lose your job, suffer a drastic pay cut, or experience a financial emergency. They can be even more valuable if you own a home.
Here is an example. Let’s say you refinance your student loans and buy a house. Six months later, you get laid off and start having trouble paying off your student loan and mortgage. You try to defer your student loans, but it runs out after a few months. You miss more mortgage payments, and eventually the bank forecloses you and repossesses the house.
While this situation may seem extreme, it is not impossible, especially since the Covid-19 pandemic has shaken job security in almost every industry. People who once felt financially well are now struggling to pay their bills. Government gave federal student loan borrowers a break in the form of an interest-free student loan patience during Covid-19 pandemic. Refinancing federal loans makes you ineligible for this relief.
You might end up paying more interest
If you refinance your longer-term student loans, you may find yourself paying more interest in total.
For example, let’s say you have $ 60,000 in loan with a 10-year term and an interest rate of 7%. If you refinance for 20 years with an interest rate of 5%, you will pay $ 301 less per month. However, since you have doubled the term of the loan, you will pay $ 11,435 more in total interest over the term of the loan.
Why deferral of student loans does not work
Some borrowers believe that deferring their student loans will reduce their DTI and make them easier to qualify for a mortgage. Sadly, Fleming says that’s not the case.
If your loans are deferred, the lender will use a proxy figure as the monthly payment when calculating your DTI. They will take your current loan balance and multiply it by 1% or 0.5%, depending on the lender. This number is what they will use to calculate your monthly payment, even if it is greater than your actual monthly payment.
For example, let’s say your monthly payments are deferred and your current balance is $ 60,000. The lender will take $ 60,000 and multiply it by 0.5% or 1%, depending on their lending standards. This will equal $ 300 or $ 600. They will use this number to determine your DTI.
This principle also applies if you have an income-based repayment plan. Lenders will not use the income-based monthly payment and instead multiply the loan balance by 0.5% or 1%. This means that suspending your payments or choosing an income-based repayment won’t necessarily make it easier to qualify for a mortgage.
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