If you are a federal student loan borrower who had a mortgage application rejected in the last year, things just got a lot better.
Under new Fannie Mae guidelines, underwriters can now base mortgage decisions on a applicant’s actual student loan payment. Previously, payments on income-driven repayment plans such as IBR, PAYE, and REPAYE could only be used for calculations in limited circumstances. If you had a large student loan balance, but were only expected to make a low monthly payment on your federal loans, mortgage writers used a different number for your student loan debt. The number used was 1% of your loan balance. That means that if you had a $100,000 student loan balance and were making income-driven payments of $200, instead of using your actual student loan payments, mortgage companies would use a $1,000 payment. This huge gap between the actual payment and the one used in credit decisions resulted in a lot of rejections — something we took issue with when the policy was first created.
Mortgage math now makes more sense
Going forward, mortgage companies can base credit decisions on a borrower’s actual monthly student loan payment, even if it is an IBR, PAYE, or REPAYE payment. The idea behind a lender looking at the debt-to-income ratio is to determine whether or not a potential borrower can afford the monthly mortgage payment for the house they want to buy. Looking at the total federal balance never made sense, so the switch back to actual monthly payments is a welcome change.
Mortgage applications that were rejected in the last year now have a much better chance of being approved.
Who does this policy help?
The biggest beneficiaries of the change will be federal student loan borrowers with large balances, such as borrowers with lots of graduate school debt. For many of these individuals, buying a house was nearly impossible under the old underwriting standards.
Going forward, any federal student loan borrower who is interested in buying a house would be wise to sign up for an income-driven repayment plan. Even if they can afford the monthly payments on their current repayment plan, the lower monthly payment will enhance their chances of getting approved at the best rates available.
Won’t this just create another mortgage bubble?
People buying houses they cannot afford is a problem for both the home buyer as well as the economy as a whole, as we learned in the last recession. While this change will allow more people to buy houses, it is not putting homebuyers in a position where they cannot afford the monthly mortgage payment.
The rational behind the old policy was that the monthly payments on income-driven repayment plans could go up. Because there was a danger of the payments going up, mortgage underwriters used much more conservative numbers for the student loan payments when evaluating applications. The problem with this approach is it ignores a simple fact: if student loan payments go up, it means income has also gone up.
It is possible for a borrower on an income-driven repayment plan to have their monthly payment double. For this to happen, it would also require their income to nearly double. Thus, a borrower who can afford a home based on their current income-driven payment will still be able to afford their mortgage if they payment goes up. In fact, an increasing student loan payment is a very good sign for the mortgage company, it means the borrower is making more money and in an even better position to meet their monthly obligations.
Mortgage underwriting standards are now much more reasonable when evaluating the debt-to-income ratios of federal student loan borrowers on income-driven repayment plans. If you are an interested home buyer who falls into this category and had a mortgage application rejected last year, your odds of approval just went way up.