Housing and the Student Debt Issue

How student loan debt affects first-time homebuyers and what they can do about it.

by Myles Biggs

As the month of May quickly approaches, the next wave of college graduates will soon enter the work force. Between entry-level jobs, consistent diets of ramen noodles and minimalistic apartment décor, these graduates will do their best to budget and save their money so that one day they can realize their own American Dream of home ownership.

However, thanks to the increasing burden of student-loan debt, many of these graduates believe that they cannot afford a mortgage. According to the Pew Research Center, the average student debt per household was $26,682 in 2010. That’s up from $17,562 in 2001 and $9,634 in 1989.

The truth – while rising student debt is indeed an issue, the bigger issue is fear of the unknown – not everyone takes a class on planning for a mortgage in college. It is important that we focus less on daunting statistics and more on arming these graduates with an appropriate understanding of how mortgage approvals work. Once graduates are aware of the factors affecting their mortgage approvals, they can put fear aside and start to adequately prepare for their future.

Understanding Your Debt-to-Income Ratio

As a recent graduate, lenders are not as concerned with the total amount of your student loan debt as they are with your total monthly debt payments and how they compare to your income. This comparison is known as your debt-to-income ratio (DTI). Lenders will calculate both a front-end DTI and a back-end DTI.

A front-end DTI compares your monthly housing expenses (mortgage payment, property tax and homeowner insurance premiums) to your income level. A back-end DTI compares your other debt responsibilities (minimum credit card payments, car loans and any other debt responsibilities) to your front-end DTI and your income level.

As a rule of thumb, lenders prefer a front-end DTI of less than 31 percent and a back-end DTI of less than 43 percent.

You can calculate your front-end DTI by dividing your monthly housing expense by your gross monthly income. Your back-end DTI would be your monthly housing expense plus any additional debt amounts (minimum credit card payments, car loans, etc.) divided by your gross monthly income. 

Understanding Your Options

There are several different types of mortgages available. Most potential first-time homebuyers do not have the same access to capital as move-up homebuyers do. If you are a potential first-time buyer concerned about affording a large down payment, you may want to research loans from the Federal Housing Administration (FHA).

FHA loans offer home buyers more flexibility with their down payment and often accept down payments of as little as 3.5% or less. Unlike traditional mortgages that require a solid down payment of 20% or more, these loans require mortgage insurance, often built into the principle and incorporated into monthly payments. Buying with a down payment of 3.5% means that do not have a high equity investment in the property. This mortgage insurance helps to protect the lenders in the event that you walk away from the loan and leave the property.

While low down payments may be enticing, they are also the reason why many homeowners end up underwater and homes go into foreclosure. Therefore, first-time buyers need to be particularly cautious about taking on a mortgage that is greater than what they can afford.

Taking Control

If your DTI does not fall within the favorable range, it is wise to pay down your student loan debt before you assume further debt in the form of a mortgage. Consider addressing your student debt in the following ways:

  1. Increase your income – a higher income will result in a more favorable DTI, improving your chances for mortgage approval. Additional income will also allow you to put more money towards your loans, effectively lowering your total debt amount and helping your DTI. Increase your income by picking up a side job, engaging in professional freelancing or by simply asking for a raise from your current employer.
  2. Make larger payments – this is the best options for those graduates who are still living with their parents and have little to no renting expense. Consider putting the money you are saving on rent into paying down your loans. This will lower your debt faster, reduce money spent on interest and get you near the DTI you need for a mortgage.
  3. Reduce your interest rates – you can reduce the interest rates on your student loans through direct withdrawal and consolation programs. Reducing interest rates by even a fraction of a percent can make a huge difference and save you tens of thousands over the life of a loan. Lower interest rates often mean lower monthly payments, which will help your DTI and improve your chances for mortgage approval.
  4. Operate Within a Budget – proper management of your finances is the easiest way to make the most out of your money. By watching your flow of money in and out, you can identify areas of excess and unnecessary spending. You can then take the money you save in various areas and apply it to your loans – slowly but surely digging yourself out of debt.

Knowledge is power. We encourage you to take these basic points and use them to jump start your own financial research and planning. Once you are ready to buy your first home, we happen to know a company with several attractive entry level floor plans for you to check out.

Do you have additional insight into the issue of student debt and first-time home ownership? Drop us a line in the comments section below.