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As student loans take on an increasing presence among the 20-something generation of college graduates who have traditionally made up a high proportion of first-time homebuyers, the impact of student loan debt on a mortgage application becomes increasingly important — especially as about two-thirds of college seniors who graduated in 2011 had student loan debt averaging $26,600.

While credit scores, cash reserves and income have always been important factors in mortgage underwriting, student loan borrowers — and their spouses/partners — face another critical factor that is driving college graduates with good jobs away from the starter home market, despite mortgage payments being less than rent in many regions. That factor is the debt-to-income ratio, or DTI.

How it Works

DTI measures the percentage of the borrowers’ monthly income taken up by mortgage payments and other debt. There are two separate DTI calculations:

Front-end ratio: Housing payment (mortgage, taxes, mortgage insurance and homeowners’ dues) as a percentage of monthly income.

Back-end ratio: Housing payment and recurring debt payments (i.e. loans and credit cards) as a percentage of monthly income.

Of the two DTIs, back-end ratios tend to be the bigger stumbling block for student loan holders, as the monthly student loan payment is included in this calculation. Guidelines for acceptable back-end DTI ratios are around 41% for mortgages backed by the Federal Housing Administration, and vary between about 36% and 45% for conventional and other types of mortgages — all at the underwriter’s discretion.

The Typical Borrower

The following example shows how a back-end DTI ratio is likely to compute for a typical student loan borrower carrying about $24,000 ($275/month) in student loan debt, which was the average in 2012; with income of $43,500 ($3,625/month), the average income for college graduates in 2012; credit card/auto/other monthly payments of $100/month; and is applying for a $200,000 mortgage ($1,275/month including principal, interest and taxes).

  • Housing payment ($1,275) + Student loan payment ($275) + Credit card ($100) = $1,650
  • Monthly income = $3,625

The back-end DTI for this borrower is 46%, which puts her at the high end of the guidelines, and the underwriter may require a high credit score and additional cash reserves.

Exceptions to these back-end DTI requirements include:

  • FHA and Veterans Affairs loan programs where the student loan will be deferred for a period of 12 or more months from the date of the loan closing.
  • Any loans, including student loans, with less than 10 months remaining.
  • An employment contract stipulating that the employer will be paying the student loan debt in addition to regular salary.

At more than $1 trillion, student loan debt has risen to all-time high levels — now exceeding credit card debt. The above example makes it clear that this ever-increasing mountain of student loan debt is not only hard on the college graduates repaying it, but by crowding out other forms of debt to buy homes and cars, student loan debt is having a detrimental impact on the real estate market — particularly when it comes to first-time homebuyers. And with a solution nowhere in sight for either the real estate market or this generation of employed college graduates looking to buy a home, something is terribly wrong with this picture.

Image: Gary Houlder

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