Student loan refinancing can be exactly the right choice for taking control of your student debt. Unfortunately, a mortgage underwriter may not see it that way. That’s why choosing to refinance student loans before a mortgage can be a problem.
Having your mortgage application stopped dead in its tracks a few days before closing is everyone’s worst nightmare. But it can be especially frustrating if this is caused by what you thought was a responsible financial decision.
Kellie, a Student Loan Planner® client, shared her struggles with refinancing student loans before a mortgage. Continue reading to learn the potential pitfalls and how to avoid them.
Kellie’s successful student loan refinancing
Kellie has been a general dentist for two years. In January 2018, Kellie refinanced her student loans to a new loan with CommonBond at lower interest rate. She opted for a 7-year repayment term, and her payments are about $2,300 per month.
“I feel great about the progress I’ve made paying down my student loan debt,” Kellie states.
She and her husband have been living with his mother for two years to help decrease the couple’s debt so she could buy a dental practice. This plan has worked so far, and Kellie purchased a practice in January 2019.
These 28-year-olds are making smart financial choices early in life. They both decided the next focus would be on starting a family and finding the perfect home in their small town.
The mortgage application pre-approval was on track
Kellie and her husband contacted Huntington Bank to ask about its doctor home loan. She heard it was one of the best mortgages for doctors. The loan looked good with no down payment or Private Mortgage Insurance required and an interest rate of 4.325%.
From the start, Kellie informed the loan officer that she had recently purchased a practice earlier in the year. The loan officer said it wouldn’t be a problem. In fact, according to Kellie, the loan officer acted 100% confident that they would qualify for the mortgage program.
In 2018, their combined income was $233,000. Kellie and her husband were promptly given a pre-approval letter for $500,000. They had already set a modest home budget of under $200,000, so everything seemed to be on track.
The next best part was that they found a home. The couple paid $400 for a home inspection and put $1,000 of earnest money down. Kellie and her husband jumped through all the hoops and were set to close on a Friday.
36 hours before closing day, their loan was denied
Monday rolled around and they hadn’t heard anything from the bank. Kellie contacted the loan officer and discovered their mortgage application was waiting on final underwriting approval.
Thirty-six hours before closing day, the lender denied their mortgage loan. They were likely not going to get financing from another bank in 36 hours and the sellers weren’t willing to extend the home purchase contract. The couple lost their earnest money and the home where they had hoped to start a family.
Behind the scenes of the mortgage application
Huntington Bank has a policy that any self-employed applicant must have at least one year of corporate tax returns to be eligible to apply for a mortgage. Despite being a dentist at the same practice for the last two years, Kellie had now become self-employed as the owner. Huntington told Kellie that because of this new ownership position, her income couldn’t be verified.
The bank removed Kellie’s income from the mortgage application but not her student loan debt. Instead, her husband’s income alone was used on the application. And that wasn’t enough to afford both the mortgage and Kellie’s monthly student loan payment.
Refinancing student loans before a mortgage can help or hurt
Refinancing your student loans can cause a hiccup in the process when it comes to debt-to-income ratio (DTI). Your DTI ratio is the percentage of your total gross monthly income that goes toward debt.
This is what happened with Kellie. Once her salary was removed from the application, this significantly changed the couple’s DTI. With a new practice and student loan payment on a seven-year payoff plan, the couple’s DTI was high. In general, it’s best to keep your DTI ratio below 36% to get approved for a mortgage.
In Kellie’s case, the loan officer suggested that she refinance her student loans again to decrease the $2,300 payment. Refinancing your student loans to lower your monthly payment can be a solid strategy. Even though Kellie had recently refinanced her student loans, she could refinance student loans more than once.
Kellie looked into this option, but found it was a dead-end road. This is because refinancing student loans required two years of corporate tax returns for self-employed applicants.
For Kellie and her husband, they had no solution to address the new DTI imbalance, since she couldn’t refinance her student loans and her income couldn’t be verified.
One factor that wasn’t highlighted in Kelli’s story was how refinancing students loans will also add a hard credit inquiry to your credit report which can temporarily ding your credit score. And that can also throw a wrench in the mortgage underwriting process.
Kellie’s future plans
Kellie has a positive outlook on her house hunt. “I know everything happens for a reason, and there will always be another house,” she says.
She cautions those looking to refinance student loans before applying for a mortgage. “…there comes a time to balance paying down debt aggressively with living life and raising a family,” she says. “I am so grateful to own my own practice, but I never thought that purchasing the practice [and becoming self-employed] would put the brakes on purchasing a home or our family planning timeline.”
Managing your students loans before a mortgage
Other than refinancing your student loans to lower the monthly payment, you could try switching payment plans. If your federal student loans are on the Standard Repayment Plan, switch to an income-driven repayment plan to lower payments and DTI. You can use a calculator to estimate your payments on these plans before applying for the change.
If you’d like to simplify your federal student loan payments, you could also apply for a federal student loan consolidation. For step-by-step instructions on how to consolidate your federal loans, check out our Direct Consolidation Loan guide.
Don’t forget that a good payment history with all of your student loans is a plus when applying for any type of mortgage. Each mortgage lender has its own set of rules. You can take a deep breath knowing that student loan debt and refinancing won’t always stop you from getting a home.
Finding mortgages with flexible requirements
Some mortgages are easier to qualify for than others. If you’ve been denied for a conventional mortgage, you may want to consider applying for one of the government-insured loan programs (FHA, VA or USDA). Another option to look into is professional mortgage loans for physicians, dentists and medical professionals.
Physician mortgages offer a low down payment and do not require mortgage insurance. The most significant part is that a physician mortgage allows higher student loan balances than conventional or Federal Housing Administration (FHA) loans.
How to refinance student loans before a mortgage
No two borrowers will have the exact same financial situation. For example, if you mostly have private student loans and you’re a W-2 employee, refinancing to a better interest rate and lower monthly payment could actually improve your DTI and your chances of receiving mortgage approval.
If you do decide to refinance your student loans before getting a mortgage, try to do so at least one year beforehand. While hard credit inquiries stay on your credit report for two years, they only affect your credit score for 12 months.
You’ll also want to make sure that you get the best deal on your student loan refinancing. In addition to looking for a lower rate, you’ll want to avoid origination fees. Other factors to consider include the lender’s forbearance and deferment options and whether it offers a cosigner release option.
Finally, make sure to compare quotes from multiple private lenders before making a decision. You can start the shopping process by checking out Student Loan Planner®’s favorite refinancing companies and the current cash bonus offers for each.