The consequences of student loan debt for the average person have caused them to put off major purchases and expenses like cars, houses, and marriage. Most college graduates understand that pairing their student loan prepayments with additional debt will present a severe barrier to achieving their dreams. In 2012, student loan debt is estimated to have exceeded $1 trillion (CollegeBoard.org). The average student loan debt per person is almost $30,000 (Federal Reserve Bank of New York, 2013).

One of the key factors in qualifying for a mortgage is the debt-to-income ratio used by lenders. Lenders use a debt-to-income ratio to calculate the mortgage payment and the borrower’s income; this is called front end ratio. For most lenders, an initial ratio can be as high as 31% of the borrower’s income. Lenders also calculate the total debt and income of borrowers. This debt-to-income ratio is called the back-end debt ratio. The debt-to-income ratio can typically be as high as 43% of the borrower’s income. Below is an example of the impact of an average person’s education loan debt on qualifying for a mortgage. For these examples, we will assume a credit card debt of $150 per month and an installment loan (car loan) of $350 per month. The income used is $48,000 per year (or $4,000 per month).

front end ratio

Under this guideline, 31% of the borrower’s monthly income ($4,000) can be used toward their mortgage obligation. This would equate to a purchasing power of $1,240. Assuming security deposits (taxes, insurance, and pmi) equal $500 per month; the buyer could obtain a 30-year mortgage of $146,000.
However, the borrower must also meet the guidelines for both the initial and final ratios. Below is an example of two different buyers, one with an average student loan debt of $30,000 with the standard 10-year repayment option and one with no student loans.

Final debt ratio

Under this guideline, 43% of the borrower’s monthly income ($4,000) can be used for all of their debt (mortgage, car, credit card debt, and student loans).

Example 1: (Buyer without student loans)

$4,000 (monthly income) x 43% = $1,720 (total allowable monthly debt)

debts

Car $350 + credit cards $150 = $500 debt (excluding mortgage obligation)

$1,720 (total allowable monthly debt) – $500 (debts) = $1,220 or $142,000 in available mortgage power *

Example 2: (buyer with $30,000 average student loan debt)

debts

Car $350 + credit cards $150 + student loan $342 (based on 10-year repayment @ 6.65%) = $842 owed (excluding mortgage obligation)

$1,720 (total allowable monthly debt) – $842 (debts) = $878 or $74,000 in available mortgage power *

• In the examples above, a fixed rate of 4.50% over 30 years was used.

In the examples above, the only difference is the average student loan debt as reported by the Federal Reserve Bank of New York. The borrower with the average student loan debt has a whopping $68,000 less in mortgage power.

One solution for prospective homebuyers with student loans is income-based repayment plans. Income-based payment plans offer the lowest monthly payment options. The maximum monthly payments are 15% of discretionary income, which is the difference between adjusted gross income and 150% of the poverty guideline based on family size and location. Payments may change every two years as income changes. Payments can continue for up to twenty-five years. This information would empower recent college graduates with the ability to modify their financial obligations in a way that allows them to qualify for a mortgage. The US Department of Education offers multiple repayment plans for education loans based on the borrower’s income. Even if a payment plan has already been selected, the payment plan can be changed at any time. According to the Federal Student Loan Aid website, income-contingent repayment plan payments are calculated based on adjusted gross income, family size, and the total amount of Direct Loans. The income-sensitive payment plan calculates monthly payments based on annual income. Generally, the minimum monthly payment option is $50, unless zero monthly payment is calculated under the income-based payment plan. Any amount not paid after 25 years of making qualified monthly payments may be forgiven, but any amount forgiven may be subject to tax.

References:

http://www.newyorkfed.org/studentloandebt/

Federal Student Aid https://studentaid.ed.gov/repay-loans/

Mishory, J. and O’Sullivan, R. (2012). Denied? The impact of student debt on the ability to buy a home. Invincible Youth.

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