IBR, PAYE, and Mortgage Applications

Michael Lux Student Loan Blog, Student Loans 1 Comment

One of the biggest perks with federal student loans is the income driven repayment plans such as IBR, PAYE, and REPAYE. What makes these plans so great is that monthly payments are determined based upon what you make, not what you owe.

If you are looking to buy a home, these plans are not looked upon fondly by mortgage companies.  In fact, they can be devastating to a mortgage application.

The Problem

The issue with income driven plans is that mortgage companies do not know how to handle them.

The underwriting process on a mortgage application is an incredibly tedious process.  The job of an underwriter, in most cases, is to make sure the loan conforms with certain criteria.  If you bring in $2,000 per month, an underwriter won’t sign off on a $3,000 per month mortgage.  If the loan meets certain standards, it can be sold off to entities like Freddie Mac and Fannie Mae.  Freddie Mac and Fannie Mae then package the mortgage loans into large mortgage backed securities to be sold as investments.

This complicated background helps explain why so much of the process is black and white, with little room for logic or explanation.  Underwriters have strict standards that must be meet, and if the standards are not met, the application will be denied.

Dealing with IBR

The problem with IBR is that the monthly payments are only good for a year.  After that, the payments can go up or down.  The mortgage company playbook does not like this instability.  Most mortgage lenders will only use an IBR payment if it fully amortizes the loan within 30 years.  Bottom line, if you have a large amount of debt that you expect to be forgiven, mortgage companies will likely ignore you IBR payment.  Instead, they will use 1% of your principal balance as the monthly payment number for your student loans.  In many cases, this number hugely overstates the actual monthly cost of the student debt.

By using a higher, unrealistic number, in calculating your monthly debt obligations, your ability to borrow is greatly eliminated.

An Example

Suppose you have $100,000 in federal student loan debt from your undergrad and masters program.  Based upon your income, you have to pay $200 per month on your student loans.

The mortgage company in most cases will not use the $200 per month number, because it will not pay of the $100,000 loan in 30 years.  Instead, they will take 1% of the $100,000 as your monthly payment… $1,000 per month.

In reality you are not paying $1,000 per month on your student loans, but that is the number the lender will insist on using in most cases.

The Absurdity

There is little benefit in trying to explain to the mortgage company that their policy makes no sense.  If you tell them that $200 is what you actually pay and each year you will re-certify IBR and it will continue to be $200, they will tell you it does not matter because the payment could go up.  Anyone who understands IBR knows that if the monthly payment is going up, then it also means the borrowers income has also gone up.  Unfortunately, mortgage companies choose not to use this logic.

A loan that you could comfortably afford can be denied due to this practice of inflating student loan payments for IBR borrowers.

A special note about $0 per month payments

If you currently owe $0 per month on your IBR payments, you can be certain that the mortgage company will use a different number when calculating your ability to pay.  If they see $0 per month on your credit report, it will almost always be treated as a deferment and the mortgage company will use a much higher number.

Bottom Line

Applying for a mortgage while on an income driven student loan repayment plan can be incredibly complicated if you have a large quantity of federal student loan debt.

However, you may have noticed that words like usually, often, and most of the time were used often in this article.  As with anything, there are some exceptions to the rule.  This week we will take a look at some of the exceptions and share some tips for applying for a mortgage while on IBR, PAYE, or REPAYE.

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Interesting. I was unaware that this issue existed. Thanks for sharing!