Smart financial moves are often about taking advantage of opportunities as they present themselves.
That’s why, with interest rates lower than they’ve been in years, many consumers are looking to buy a home or refinance their student loans. So if you’re a prospective home buyer and a student loan borrower, is there any reason why you can’t do both?
As with most questions like this, the answer depends on your individual circumstances. Here’s when it makes sense to buy a home and refinance your student loans at the same time—and when doing so just isn’t worth the risk.
How Student Loans Affect Your Ability to Buy a House
When you have a student loan balance, it can affect your debt-to-income ratio (DTI), which is one of the most important factors that lenders consider. DTI is your monthly debt payments, including your future mortgage payments, divided by your monthly gross 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 will usually allow a maximum DTI of 36%, while lenders who provide Federal Housing Administration (FHA) or Veterans Administration (VA) loans will permit a DTI as high as 43%. U.S. Department of Agriculture (USDA) lenders have a maximum DTI of 41%.
Having a high monthly student loan payment will contribute to your DTI and will help determine how much of a mortgage you qualify for.
For example, let’s say your gross income is $4,000 a month. You decide to use an FHA lender, so your maximum DTI is 43%, or $1,720 a month. Your student loan payments are $1,000 a month, so you only qualify for a $720 monthly mortgage payment.
If the homes you’re interested in have mortgage payments that would exceed that figure, your only options would be to lower your housing budget or decrease your monthly student loan payment by refinancing your student loans.
Pros of Refinancing Your Student Loans
There are several reasons why refinancing student loans before buying a house 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 pick an FHA lender, which puts your maximum DTI at 43%, or $1,290 a month. Your current student loan payment is $500 a month on a 10-year repayment plan. You decide to refinance your student loans and end up decreasing your monthly payment to $300. This frees up more money and means you now qualify for a bigger mortgage than if you hadn’t refinanced your student loans.
Help You Save for a Down Payment
If you refinance your student loans and decrease your monthly payment, you can use the extra cash flow to save for a down payment, moving expenses and closing costs.
Having a lower monthly payment on your student loans will also help after you buy the house because you’ll have more money to cover any potential home repairs or remodeling projects.
Cons of Refinancing Your Student Loans
There are also some downsides to refinancing your student loans. Here’s what you should be aware of.
It Could Hurt Your Credit Score
Casey Fleming, a San Jose, California-based mortgage adviser and author of “The Loan Guide: How to Get the Best Possible Mortgage,” says refinancing your student loans can decrease your credit score. That’s because lenders perform a hard credit check in order to evaluate your credit and determine your eligibility and interest rate. Fleming says it could take several months to bounce back from the points lost after a hard inquiry. It takes two years for a hard inquiry to fall off your credit report.
You still may be approved for a mortgage, but in turn receive a higher interest rate because of the lower score. Lenders determine interest rate partially based on your credit score, so a lower score could result in a higher rate.
Because every individual’s finances are different, Fleming recommends that you talk to a loan officer about your particular situation to find out if refinancing will hurt or help you. Look at your credit score before you reach out to anyone, as they’ll need this information to answer any questions.
You can view your credit score for free on various personal finance websites, and many banks and credit card providers also let you see your credit score for free, including American Express, Capital One, Chase and Discover.
You’ll Lose Out on Federal Loan Protections
Refinancing federal loans may decrease your DTI and increase the odds of getting a mortgage, but it could leave you open to other issues.
When you refinance federal student loans, they turn into private loans. That means you give up valuable federal loan perks like deferment, forbearance and income-driven repayment options. While some private loans have deferment and forbearance programs, the timeline is never as generous as what the federal government offers.
These benefits can help if you lose your job, take a drastic pay cut or have any kind of financial emergency. They can be even more valuable if you own a house.
Here’s an example. Let’s say you refinance your student loans and buy a house. Six months later, you get laid off and begin to have trouble making your student loan and mortgage payments. You try to defer your student loans, but that runs out after a few months. You miss more mortgage payments, and eventually the bank forecloses on you and repossesses the house.
While this situation may sound extreme, it’s not impossible especially since the Covid-19 pandemic upended job security in almost every industry. People who once felt financially comfortable are now struggling to pay their bills. The government has given federal student loan borrowers a break in the form of interest-free student loan forbearance during the Covid-19 pandemic. Refinancing federal loans makes you ineligible for that relief.
You Could End Up Paying More Interest
If you refinance your student loans to a longer term, you could wind up paying more interest in total.
For example, let’s say you have $60,000 in loans with a 10-year term and a 7% interest rate. If you refinance to a 20-year term with a 5% interest rate, you’ll pay $301 less per month. However, because you doubled the term, you’ll pay $11,435 more in total interest over the life of the loan.
Why Deferring Student Loans Doesn’t Work
Some borrowers think deferring their student loans will lower their DTI and make it easier to qualify for a mortgage. Unfortunately, Fleming says that’s not the case.
If your loans are deferred, the lender will use a stand-in figure as your monthly payment when calculating your DTI. They will take your current loan balance and either multiply it by 1% or 0.5%, depending on the lender. That figure is what they’ll use to come up with your monthly payment, even if it’s 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. That will either equal $300 or $600. They’ll use that number when determining your DTI.
This principle also applies if you’re on an income-driven repayment plan. Lenders won’t use the income-based monthly payment and will instead multiply the loan balance by either 0.5% or 1%. That means pausing your payments or choosing income-driven repayment won’t necessarily make it easier to qualify for a mortgage.
