Q. My wife (28) and I (27) just got married and we are hoping to buy a small starter house sometime in the next three years. We’ve discussed finances [a lot] so we feel ahead of the curve there.
I make $65,000 a year as an engineer and she makes $32,000 at a non-profit. We have a four-month emergency fund of $10,000 and plan to have $20,000 as a down payment as early as next summer. The only debt we have is my wife’s student loans: $109,000 for her bachelor’s and master’s degrees in a mix of private and federal loans.
What will be our best approach when looking into mortgages? Will her student loans hurt our chances of mortgage approval? Should I consider applying without her? Should we shift some of the money we had intended for a down payment towards the student loans to improve our debt to income ratios (and put off buying the house)? – Mike
A: When deciding to approve a mortgage, banks look at three things:
- Credit scores
- Amount and stability of income
- Debt-to-income ratio
The debt-to-income (DTI) ratio is the big question mark that you will need to watch closely.
To calculate DTI, add up your total monthly debt payments (including the prospective mortgage payment) and divide it by your gross (pre-tax) income. Although the criteria vary by lender, it’s my understanding that banks want to see a total debt-to-income ratio of 40 percent or less.
I don’t know your monthly student loan payment, but I ran a quick calculation on a $109,000 balance over 10 years at an average six percent interest rate. That has a monthly payment of $1,210.
Making $8,083 a month, you could have monthly debt payments of up to $3,233 and fall within banks’ lending criteria. With the $1,210 loan payments, you could take on a mortgage payment of up to $2,023 (including taxes and insurance).
The operative word, of course, is “could”.
We money hackers know that just because a bank will let us do something doesn’t mean we should! In my opinion, paying 40 percent of your gross income towards debt each month is pretty scary. Consider that:
- Figuring in taxes, you’ll be paying more than 50 percent of your take-home pay towards debt.
- If one of you were to lose your job and you drain your emergency fund, keeping up with all of your expenses will be extremely difficult. You’d be house poor.
I would be more comfortable with a maximum debt-to-income ratio of 25 percent. As an example, the only debt my wife and I carry now is a 20-year mortgage and a small federal student loan with a five percent APR, and our debt-to-income ratio is about 14 percent.
You and your wife need to figure out your comfort zone. If you’re ready to settle down and believe that your incomes will go up and your student loans will be paid off eventually, you may be willing to live with a higher ratio now knowing that it will go down in time…that’s a gamble that many young Americans make (or at least used to make before 2008!)
As a final note, you asked about applying for the mortgage on your own. You can do this, but your application will be based upon your credit and your income alone.
In addition to the maximum debt-to-income ratio banks require, they have a lower threshold for the maximum housing payment they will approve (the mortgage payment including taxes and insurance). This is usually 28 or 30 percent of gross monthly income. So if your income alone is $5,417, you could get a mortgage payment of up to $1,517 using the 28 percent rule.
Result: Even with your wife’s loans, you could still borrow more together. But again: not that you should.
What would you do if you were in Mike’s shoes? Have you bought a house in spite of big student loan debts? Do you feel it was the right move? Pitch in with a comment.
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