With rents rising in hot job markets around the country, many millennials who are paying down student loan debt are understandably anxious about missing out on the chance to become homeowners while mortgage rates are hovering near historic lows.
Those monthly student loan payments not only make it harder to save up for a down payment. They can nudge debt-to-income ratios into territory considered off-limits by mortgage lenders.
Yet, over the last 10 years, there’s been a 40 percent increase in the number of mortgage holders who are also paying down student loan debt, from 5.4 million in 2006 to 7.7 million today.
Thanks in part to their sheer numbers, millennials now account for more than one in three home purchases — more than any other generation. The National Association of Realtors estimates that 44 percent of millennial homebuyers have student loan debt, with a median loan balance of $25,000. How can that be?
When student loan debt is, and is not, a problem
With student loan debt, it’s not necessarily how much you owe, but what you got for the money you spent. A degree that boosts your earnings power is an investment in your future that makes your student loans more manageable.
So who’s most likely to default on their student loans? It’s borrowers who have small loan balances but didn’t get their degree. Default rates are highest among borrowers who owe less than $5,000. They’re almost 50 percent lower for those leaving school with more than $100,000 in educational debt.
A recent study by real estate data aggregator CoreLogic found that among millennials age 20 to 34, having more student loan debt was associated with higher FICO scores. That’s right, the more student loan debt millennials have, the higher their FICO scores are likely to be.
But even when student loan debt is manageable, paying down loans can still make it more difficult to save for a down payment. Or to qualify for a loan that’s big enough to buy a home you’d actually want to live in, without sending your debt-to-income ratio soaring into the stratosphere.
Tips for millennial homebuyers
NAR’s latest survey of homebuyers reveals some approaches that millennials with student loan debt are taking to become homeowners.
For one thing, millennials tend to buy smaller, older and cheaper homes. Gen X buyers are shelling out $250,000 on average to buy homes with about 2,200 square feet of floor space. Millennials are happy to pay $180,900 for homes averaging 1,720 square feet.
Millennials are also making smaller down payments, sometimes with help from their parents. The median down payment for millennial buyers is 7 percent. But keep in mind that putting less than 20 percent down often means the added expense of mortgage insurance. Plus you’ll have less equity in your home to start out.
Many states offer programs that help first-time homebuyers cover their down payments. Some programs specifically target student loan borrowers and recent grads.
Taming student loan debt
Another way student loan borrowers can put themselves in a better position to become homeowners? Reduce the burden of their existing debt.
Federal loan consolidation and private refinancing are two distinct strategies for managing student loan debt that are sometimes confused. Each approach has pros and cons, and it’s important to understand the differences.
Student loan consolidation
Most federal student loans are eligible to be combined into a single new federal loan, called a Direct Consolidation Loan. If have multiple federal loans, consolidating them lets you make one monthly payment.
Drawbacks include the fact that private loans aren’t eligible for federal loan consolidation. And you won’t get an interest rate reduction. The interest rate on your new loan will be a weighted average of your existing loans, rounded up to the nearest ⅛ percent.
Your monthly payment can be more manageable after consolidation. The repayment term on high-balance consolidation loans is stretched out over a greater number of years. But stretching out your payments can increase total repayment costs.
Another way to lower the monthly burden of federal student loans? Enroll in an income-driven repayment plan, which ties payments to a percentage your disposable income. Depending on the plan you enroll in, you could qualify for loan forgiveness after 20 or 25 years of payments. (Government and nonprofit employees may qualify for Public Service Loan Forgiveness after 10 years of payments).
As is the case with federal loan consolidation, income-driven repayment plans don’t provide an interest rate reduction. That means borrowers can end up paying more in the long run as they stretch out payments over many years, particularly if they don’t qualify for loan forgiveness.
Student loan refinancing
Borrowers who are looking to lower their interest rate can refinance private and federal student loans with a private lender. Refinancing at a lower rate can lower both your monthly payment and the total amount repaid.
The rate you qualify for will depend both on your credit history and the repayment term of the loan you pick. The shorter the repayment term, the lower the rate. But you may be able to reduce your rate even if you refinance into a loan with a longer repayment term and lower monthly payments.
The choices available when refinancing allow borrowers to pursue a strategy that best fits their needs. There’s a lot of competition among lenders. Shop around to find an offer that’s right for you.
To get the biggest interest rate reduction and maximize overall savings, some borrowers will choose to refinance into a loan with a shorter repayment term and higher monthly payment.
Other borrowers are more concerned about reducing their monthly payment. In that case, refinance into a loan with a longer repayment term. Getting an interest rate reduction can help minimize the impact of extending your loan term.
An analysis of borrowers who used the Credible marketplace to refinance into a loan with a longer repayment term found that they reduced their interest rate by an average of 1.36 percentage points, cutting their monthly student loan payment by $218.
Get a bigger mortgage
Refinancing student loans to lower your monthly payment may not only help you qualify for a mortgage, it can also help you afford a bigger mortgage.
Let’s you can afford a mortgage payment of $1,314 a month. That would allow you to take out a $300,000 30-year fixed-rate mortgage at 3.3 percent interest. If you were able to reduce your monthly student loan payment by $218, you could afford to take out a $350,000 mortgage with monthly payments of $1,532.
In many markets where housing inventory is scarce, having another $50,000 in bidding room can make the difference between going to the closing table and sitting on the sidelines.
Refinancing student loan debt is not for everybody. You’ll lose access to borrower benefits like access to income-driven repayment programs and the possibility of loan forgiveness. But thousands of borrowers have already decided that the savings they can realize are worth giving up those perks.
Like buying a home, the decision to refinance student loans hinges on your own, unique circumstances. Rather than assuming that either is out of reach, borrowers owe it to themselves to explore the possibilities.