A house, 2.5 kids, and a white picket fence: it’s the classic American dream. But with the cost of a four-year degree rivaling (if not surpassing) the cost of a modest home, some fear that young America’s ability to attain those decades-old aspirations could be threatened.
A report by Young Invincibles, a policy resource organization, recently looked at how rising student debt levels affect the young college graduate’s ability to buy a home.
As the study points out, one of the primary measurements that determine whether or not an individual qualifies for a mortgage is the debt-to-income ratio, or DTI.
In the past, mortgage lenders were often more willing to offer some flexibility on DTI when student loans were involved. However, the recent economic and mortgage crisis has forces most mortgage loan providers to tighten their DTI requirements, so as to better ensure that prospective loan borrowers can actually afford their loans.
More specifically, lenders generally calculate the back-end debt-to-income ratio, which provides a complete overview of the borrower’s total long-term obligations – and that person’s ability to adequately handle those debts.
Mortgage lenders typically review two DTI calculations: the front-end and back-end debt ratios. The front-end looks at the borrower’s housing payments, particularly the projected PITI (mortgage principal, interest, tax and insurance) payments, as well as related expenses such as condo dues and homeowner association assessments.
In contrast, the back-end DTI ratio adds all other long-term debt obligations to the front-end calculation. It takes three groups of consumer finance factors into account:
- Potential housing payments. This figure includes mortgage loan payments, monthly portion of real estate taxes, monthly homeowner’s insurance premiums, mortgage insurance premiums (which are required when the borrower makes a down payment of less than 20% of the purchase price) and other ongoing assessments related to the home.
- Recurring debt. This portion includes student loans, personal loans, automobile loans and other installment loan obligations that will require at least six more months of payments. If the borrower has credit card balances, the lender will typically use 5% of the total balance as the projected monthly payment for the DTI calculation.
- Gross monthly income. For the DTI calculation, mortgage lenders look at the gross monthly income, before taxes and insurance deductions.
The Federal Housing Administration sets a guideline cutting off eligibility at 41% for back-end or long-term DTI, but conventional lenders may sometimes provide some additional flexibility. That being said, the individual in the above example might struggle to qualify for a mortgage given their debt-to-income ration. However, since there are other factors that contribute to mortgage qualification decisions, including credit scores and down payments, this individual is not necessarily out of luck.
This equation clearly takes debt – student loans included – into account. To find out exactly how student debt affects first time homebuyers, the report estimated average debt and housing payments for young adults with outstanding student loans at varying income levels. Results were split up according to marital status (which studies show can also be influenced by student debt). Here is what the Young Invincibles concluded:
- A single person with average debt would be “severely limited in home purchasing capability”
- A two-debtor household would have “potential difficulty in home buying”
- A household with one debtor would have “a much easier time affording a house”
While student loans don’t necessarily price all college graduates out of the housing market forever, studies show that they can certainly delay the process.
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