There are more than 44 million borrowers who collectively owe $1.5 trillion in student loan debt in the U.S. alone. The average student in the Class of 2016 has $37,172 in student loan debt. The payment on that debt is directly impacting the ability of many potential home buyers to get the home they want or their ability to even purchase a home. College students don’t understand what the long term impacts are of taking on much of the debt that colleges make it easy to acquire. Only when they try to buy that first car or first home do they start to understand what the full cost of college really was.
What is the American Dream?
Wikipedia states: “The American Dream is a national ethos of the United States, the set of ideals in which freedom includes the opportunity for prosperity and success, as well as an upward social mobility for the family and children, achieved through hard work in a society with few barriers.”
About two-thirds of high school graduates enroll in a 4 year college. For many, a college education has been thought to be the first step towards the opportunity to attain the American Dream. But, according to the Department of Education, the 6-year graduation rate (150 percent graduation rate) for first-time, full-time undergraduate students who began seeking a bachelor’s degree at a 4-year degree-granting institution in fall 2010 was 60 percent.
Parents, high school guidance counselors, and peers push many high school graduates into attending college. College is expensive. Many, if not most, of those students will take on some amount of debt. If they don’t graduate, they still have pay the debt incurred. That debt impacts their ability to qualify for a mortgage. For many, homeownership is what epitomizes the American Dream. For those that do graduate, they are saddled with some amount of student debt. But in theory, have a degree which will allow them to start out at a higher paying new job better positioning them to pay the debt back.
For Americans in their 20s and 30s, homeownership is hovering near a 30 year low. Only 35 percent of households headed by someone younger than 35 owned a home in 2017. That was down from 41 percent in 1982, according to census data. Now, they are much more likely to be living at home with their parents or grandparents.
How Student Debt Impacts Your Home Buying Ability
Many factors impact your ability to qualify for a mortgage. But student loans, because of their balance size and long-term repayment schedules, can significantly impact the home-buying process. When it comes to getting a mortgage with student loans, the lender needs to determine if you are able to handle a mortgage payment. It doesn’t matter what you think. There are two ratios used to determine that for you. They are typically known as your front-end ratio and your back-end ratio.
A front-end ratio is also known as the housing ratio. This ratio is calculated by dividing your projected monthly mortgage payments by your gross monthly income (your income before taxes). Your projected mortgage payment will include the costs of the principal, taxes, insurance, and interest payments, collectively known as PITI.
You earn $60,000, which is $5,000 per month
Your PITI comes to $1,450 per month
$1,450 / $5,000 = 0.29, or a front-end ratio of 29%
Your lender will set the terms, or the limits, for conventional loans. Depending on the lender, expect a limit of 28% for the front-end ratio. Federal Housing Administration (FHA) loans allow for a maximum front-end ratio of 31% as of 2018.
The back-end ratio accounts for all of your debt payments in comparison to your income. Your lender will calculate this ratio by adding your monthly debt payments and then dividing that number by your gross monthly income. These debt payments include the PITI on your mortgage, child support, car payments, credit card minimum payments, AND your student loans.
Here’s an example:
You still earn $60,000, or $5,000 per month
Your PITI is still $1,450 per month
You have a credit card balance with a $75 per month minimum payment
You have a student loan with a $225 per month minimum payment
You have a car payment of $200 per month
Let’s determine your back-end ratio:
Your monthly debt payments come to $1,950
$1,950/$5,000 = 0.39, or 39%
Here’s the gotcha: Most conventional lenders prefer to see a back-end ratio under 36%. Without the student loan debt, this back-end ratio would have been 34.5%. If you take out an FHA loan, the highest back-end ratio you can hold is 43%. This example illustrates how a student loan can interfere with your ability to qualify for a conventional mortgage.
Mortgages and the Income-Based Repayment Plan (IBR Plan)
Getting started out of college is hard. Rent, car payments, and just general living expenses can make just getting by difficult. To help, many opt for an Income-based Repayment Plan. Getting a mortgage while on any type of income-based repayment plan is a challenge and can be impossible for some. The reason is that Fannie Mae and Freddie Mac, the two largest mortgage insurance companies (they pretty much set the rules for “conforming” loans), have created rules for evaluating borrowers under income-driven repayment plans.
Fannie Mae’s guidelines state that a lender must use one of the following to calculate the debt payment for the student loan for the debt-to-income ratio:
- The payment amount listed on the credit report, not the amount due (even if it’s an income driven repayment plan like IBR)
- 1% of the outstanding balance (which is almost always higher than the IBR payments)
- The actual Standard plan repayment amount reported on the credit report (this is the most common method lenders choose because it’s the easiest). Remember, your credit report will always show your standard 10-year amount for “Amount Due”, not the amount you actually pay
- A calculated payment that will fully amortize the loan over the repayment period (this means that you have to calculate a payment with no forgiveness after 20/25 years). This could be equal to your IBR payment or higher.
Cosigning for Student Loans Impacts a Parents Home Buying Opportunities
Parents sometimes get asked to cosign a student loan for their children (this only happens on private student loans). While cosigning can help a child obtain a private student loan or get a lower interest rate on the loan, it carries a lot of risks that may not be completely understood by the parent. Cosigning a loan can be hazardous to the cosigner’s financial health.
Many mistakenly believe that a cosigner is just a guarantor or contingent borrower and merely helps the child get a student loan for which they otherwise wouldn’t qualify. But the obligations associated with cosigning are much more than most realize. A cosigner is actually a co-borrower and they are equally obligated to repay the debt.
This has a significant consequence for the parent cosigner’s credit. The cosigned loan is treated on the parent’s credit report as though it were borrowed by the cosigner because the cosigner really did borrow the money. It doesn’t matter if it is “really” the student’s loan, because the cosigner is also a borrower. This may make it more difficult for the cosigner to qualify for new credit. This directly impacts the ratios for the parent when they try to refinance a current mortgage or qualify for a new mortgage when they attempt to purchase a new home. If the student is late with a payment or defaults on the loan, it will be reported as a delinquency or default on the parent cosigner’s credit report, too. A single late payment will damage an otherwise good credit score for both the student borrower and the parent cosigner.
Steps You Can Take to Prepare for Building Your New Home
Student loan debt will be used to calculate your ratios when qualifying for your construction loan when you build a new home as well as your permanent mortgage. But you have options to help you qualify for the home you want. Here are some tips:
- There are some lenders will allow you to have a back-end ratio that’s as high as 50%. Of course, you have to have great credit. Look around and search for these lenders.
- If you have loans with small balances (for example, small credit card balances), wiping these out completely will help reduce your back-end ratio.
- Save more down payment. By increasing your money down, you lower your PITI which improves your ratios.
- Another option is to find a less expensive house which would lower your PITI.
Once you have done everything to reduce your debt payments you will see a corresponding reduction in your debt ratios. The next option to reduce your ratios is to increase your income. Ask your boss for a raise! Student debt isn’t killing the American Dream – it’s just making home buyers have to work harder and work smarter to get it.