For many years, student debt had been a significant obstacle for borrowers hoping to buy a home.
Changes to mortgage standards will allow many more student loan borrowers to qualify for a home loan. Unfortunately, the Covid-19 forbearance on federal loans may present a new — but fixable — obstacle on applications.
Old Mortgage Math: How Student Loans Ruined Home Loan Applications
Debt-to-Income ratios are a critical part of any mortgage application. Lenders compare your monthly bills to how much you earn each month. Lenders usually use the monthly payment reported by lenders on your credit report.
The issue for many borrowers was how lenders looked at income-driven repayment plans. When lenders did the math to determine how big of a mortgage an applicant could afford, they refused to consider monthly IDR payments.
The lenders decided that it wasn’t a safe number to use in debt-to-income ratio calculations because monthly payments could go up. Instead, they used 1% of the total loan balance, a much larger number for most borrowers. As a result, student loans hurt many mortgage applications.
The Big Change: Logic Enters the Equation
Most Lenders now recognize that an increase in IDR payments means a salary increase. Thus, if IDR payments did go up, the borrower could still afford their monthly mortgage bill.
The shift to accepting monthly payments on repayment plans like IBR, PAYE, and REPAYE first started in 2017 with Fannie Mae.
In 2018, mortgage giant Freddie Mac made a similar change to its mortgage guidelines.
Most recently, the Federal Housing Administration updated FHA loan standards to allow income-driven payments in DTI calculations.
Freddie Mac and Fannie Mae might not be household names, but they buy about two-thirds of all mortgages in the United States. In other words, the majority of mortgage loans must comply with Freddie Mac and Fannie Mae standards.
FHA loans are a popular tool for many first-time homebuyers with limited funds to make a downpayment.
After the Fannie Mae, Freddie Mac, and FHA changes, student loan borrowers will face fewer hurdles trying to get a mortgage approval.
The Missing Piece of the Puzzle: $0 Per Month Payments
Federal borrowers who qualify for $0 per month IBR, PAYE, or REPAYE payments still have an issue.
If the monthly payment is $0, lenders treat that as a forbearance or a deferment. While the new FHA guidelines now allow lenders to use .5% instead of 1% for the DTI calculations, this is still a setback for borrowers.
The group of borrowers impacted by the $0 payment rule is particularly large right now due to the federal interest and payment freeze.
The Covid-19 Payment Freeze and Mortgage Applications
If the good news for borrowers is that mortgage lenders will now start using the IDR payments reported on credit reports, the bad news is that most borrowers no longer have an IDR payment listed on their credit report.
In preparing this article, I pulled my annual credit report from Experian. The credit report does not show a monthly payment starting in April 2020 due to the federal student loan payment and interest freeze.
The payment freeze has become an issue for federal borrowers looking to get a mortgage. It doesn’t make getting a loan impossible, but it does make things more difficult.
Providing Lenders a Monthy Payment if Your Credit Report Says $0
The exact underwriting standards vary from one lender to the next. It is possible that a borrower could get a letter from their loan servicer showing their monthly IDR payment once the interest freeze concludes.
This approach might not work, and a lender could change its mind a the last minute.
The borrowers who desperately need an IDR payment in their DTI calculations may opt out of the payment suspension. Those who opt-out will still have a 0% interest rate for as long as the freeze lasts, but they will have to resume making payments. Crucially, the monthly payment will return to their credit report.
Mortgage Math and Income-Driven Repayment Plans
For years, borrowers on IDR plans had a tough time qualifying for a mortgage.
In some cases, changing repayment plans was necessary to get student debt ready for a mortgage application.
Today, mortgage underwriters have mostly fixed the old IDR issues. The Covid relief presents a minor hurdle, but most student loan borrowers can apply for a mortgage using a student loan payment that accurately represents their circumstances.