Lets face it – there is no better investment than education. It is the grand equalizer in our society. It enables social mobility – the ideal that one may come from nothing and yet, through education and hard work, achieve great things in life. This is a notion that has inspired generations of Americans since the founding of our country.
Unfortunately, the cost of formal education is getting out of control and the ripple effects throughout the economy are severe. More and more college graduates are entering the workforce mired in student debt that ties them to their jobs and limits their opportunities for starting a business and forming a household of their own.
In fact, student loan debt is one of the major factors keeping younger potential first-time homebuyers out of the housing market. Student loans disproportionately affect younger homebuyers in two significant ways:
- By lengthening the time it would take to save for a minimum down payment and cover the closing costs.
- By increasing the debt-to-income ratio to the point where the homebuyer may not qualify for a mortgage.
Down payment and closing costs
Let’s do some basic math to figure out the impact of student loans on a homebuyer’s ability to save enough money to cover the down payment and closing costs.
For many loan programs, the minimum down payment requirement is 5% of the purchase price and the closing costs can add up to another 3%. Unless one takes advantage of a down payment assistance program, the amount of cash needed to purchase a $200,000 home is $16,000 (i.e. 8% of the purchase price).
Now let’s figure out how long it would take a young homebuyer to save $16,000. According to the National Center for Education Statistics, “in 2011, the median of earnings for young adults (ages 25-34) with a bachelor’s degree was $45,000.” That’s about $3,750 per month before taxes, which results in about $3,000 after taxes and other pre-tax expenses such as health insurance. Take out your typical household and “young adult” expenses – such as grabbing a drink with friends on a Friday night and paying student loans, of course – and you may be left with $250 per month to save towards your home purchase. At this rate, it would take the average young homebuyer over five years to be able to buy a $200,000 home.
What if the average young homebuyer didn’t have to make the monthly student loan payments? Well, the average payment on a standard 10-year repayment plan for someone owing $25,000 is $290 per month. Free from this monthly payment, this young homebuyer could now save an additional $290 towards their home purchase, bringing the monthly savings to $540 per month ($290 plus the $250 from before). At this rate, it would take them about 2.5 years to be ready, not 5+ years. Considering the millions of young homebuyers out there with student debt, you can clearly see the impact this has on the housing market and on our economy. And it doesn’t end there…
The Debt-to-Income Ratio (known as DTI) is simply your monthly debt payments divided by your gross monthly income. Ideally, your DTI should be between 36% and 45%.
Monthly student loan payments must be factored into your DTI (even if they’re currently in deferment). Assuming the same monthly pre-tax income of $3,750 and monthly student loan payment of $290, the weight of student loans on DTI is about 8% ($290 divided by $3,750).
What does this mean in practical terms? Using a simple mortgage calculator, this means that this homebuyer can purchase about $50,000 less home because the maximum monthly mortgage payment they can afford is $290 lower.
The million-dollar question (pun somewhat intended) is what to do about our country’s growing student debt crisis. Do we offer more low-cost financing options to students? Should we increase our funding for grants and scholarships to deserving students with financial needs? The solution must somehow involve controlling the cost of education more effectively.
This author is very interested in hearing your thoughts on this topic. Let the conversation begin!
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