Why Too Much Student Loan Debt Could Derail Your Mortgage

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According to a recent report by the Federal Reserve Bank of New York, a higher percentage of college graduates have fallen behind on their student loan payments. Many of them will run into problems down the road, when applying for a mortgage loan to fund a home purchase.

Here’s an updated look at the student loan debt “bubble” that is growing in the U.S., and how it can turn a mortgage approval into a mortgage denial.

More Than 20% of Borrowers Delinquent on Student Loan Payments

The New York Fed’s quarterly report revealed a startling statistic that was buried in the footnotes. According to their data, about 11.5% of student loan debt was 90+ days delinquent or in default, during the second quarter of 2015.

But the actual number of borrowers who are significantly behind on their payments could be twice that number — or more. As the Federal Reserve Bank explained it in a corresponding footnote:

“…delinquency rates for student loans are likely to understate actual delinquency rates because about half of these loans are currently in deferment, in grace periods or in forbearance and therefore temporarily not in the repayment cycle. This implies that among loans in the repayment cycle delinquency rates are roughly twice as high.”

That means the actual delinquency / default rate could be 20% or higher. In a separate but related report issued earlier this year, the Federal Reserve Bank of St. Louis put the number even higher. Their analysis suggested “a delinquency rate of 27.3 percent for borrowers with loans in repayment.”

So yes, it’s a big problem. And for those graduates who attempt to buy a home a few years out of college, it could be a bigger problem than they realize.

The bottom line is that student loan debt can affect mortgage loan approval in a negative way. Having too much debt in relation to one’s income (and/or having a history of delinquency and default) can make it much harder to get approved for a home loan. To understand why, we have to talk about credit scores and debt ratios — both of which are very important during the mortgage application process.

Student Loans Affect Your Debt Ratios, and Mortgage Approval

Student loan debt by itself isn’t a mortgage killer. In fact, having a student loan on the books could actually improve your shot at qualifying for a home loan. Or it could throw up additional obstacles for you. The difference has to do with (A) your loan repayment history, and (B) the total amount of debt you carry in relation to your monthly income. These two factors can help or hamper your quest for a home loan.

Student loan debt can directly affect mortgage approval because it influences your debt-to-income ratio, or DTI. This is a numerical (percentage) comparison between the amount of money you earn each month, and the amount you spend to cover your recurring debts — such as student loan payments.

Related: New rule could ease debt requirements

From a mortgage lending standpoint, you have two DTI ratios. The “front-end” number uses housing-related debts only. The “back-end” DTI looks at all of your monthly debts combined (car payments, student loan, credit cards, estimated mortgage payment, etc.). While they’ll look at both numbers, lenders are mostly concerned with your total or “back-end” debt-to-income ratio. After all, it’s a better indicator of a person’s ability to repay a home loan.

Student loan debt contributes to your back-end DTI ratio, and therefore affects your ability to qualify for mortgage financing. Different lenders have different standards where debt is concerned. Many of them draw the “line” somewhere around 43% – 45%. So, by this commonly used standard, a borrower with a total debt-to-income ratio higher than 45% might have trouble getting approved for a home loan.*

Just to be clear, having too much debt can be a problem regardless of how you’ve handled your payments in the past. A borrower with an excessive debt load will likely have trouble landing a mortgage loan, even if he or she has never missed a single payment in the past.

This is just one of the ways student loan debt can affect mortgage approval. There’s another factor to consider as well, and that’s your credit score.

How Your Payment History Affects Your Credit Score

Lenders measure risk in various ways. But the goal is always the same. They want to know how much risk a borrower brings to the table, in terms of default. Borrowers with a history of repaying their debts on time have a better chance of being approved for a home loan. On the other hand, borrowers with late payments, delinquencies and/or defaults in their past could have a much harder time getting approved.

This is another area where student loan debt can affect mortgage approval. And it could be a problem for an increasing number of future home buyers, based on the statistics that began this article.

Mortgage lenders use credit scores to assess risk. A higher score indicates a lower risk of default, and vice versa. So a borrower with excellent credit has a better chance of getting approved for a home loan. Computers generate credit scores based on a handful of scoring factors. Of all the scoring factors they use, a person’s “payment history” weighs the most.

According to myFICO, the company that designed the widely used FICO score, “credit payment history determines 35% of a FICO Score.”

This is another way student loan debt can impact mortgage loan approval. Borrowers with a history of late payments usually end up with lower credit scores as a result of their delinquencies. So lenders see them as having a higher risk of mortgage default. Borrowers in this category tend to have a harder time getting approved for loans, and usually pay more interest as well.

On the other hand, a pattern of responsible credit usage (i.e., paying one’s bills on time) could result in a higher score and a better chance of getting a loan. When it comes to mortgage approval, much depends on the borrower’s total debt load at the time of application, as well as the payment history.

It’s also important to realize that these factors can be deal-breakers on their own, or in combination with one another. For example, a borrower with a reasonable debt-to-income ratio but a pattern of late payments might be turned down for a home loan. Likewise, a borrower with a good credit score and a pattern of paying bills on time might be turned down for having too much debt. When you combine these negative factors (a high DTI and a bad credit score), it can put mortgage financing even further out of reach.

The Bottom Line for Borrowers

Does student loan debt affect mortgage approval? Absolutely. But it’s not necessarily a deal-breaker by itself. In fact, having a positive payment history on loans and other forms of credit could improve your chances of getting a home loan.

On the other hand, borrowers with delinquencies or defaults in their past could face additional scrutiny when applying for a mortgage loan. And it seems as though more and more college graduates are headed down this path.

* The debt-to-income standards mentioned above reflect industry trends at the time of publication. But those numbers are not set in stone. Lenders can, and often do, make exceptions for borrowers they feel are good candidates for a home loan. So don’t be discouraged by anything covered in this story. This article is meant to educate future home buyers on the connection between student loan debt and mortgage approval. It is not the “final word” on the subject, nor does it constitute financial advice.