As many recent college graduates look forward to the exciting prospect of buying their first home, student loan debt weighs heavily upon them. For many borrowers carrying student loan debt, income-driven repayment plans(IDR) are their only financially viable repayment option. For some borrowers, they will just be on IDR plans until their salaries eventually rise.
For many others, they hope to participate in IDR more or less permanently, until whatever point decades in the future they can have their loan balances forgiven. While it isn’t known how many students in the U.S. are currently enrolled in IDR plans, a significant portion of college graduates have signed up for them. Now, their chances of getting a mortgage have just gotten a lot more difficult – especially for those carrying student loan debt, such as recent law school and medical school graduates.
Just as recently as 2016, the underwriting guidelines for two of the largest purchasers of mortgages in the country – Fannie Mae and Freddie Mac – changed regarding the use of IDR to calculate a borrower’s debt-to-income ratio (DTI).
To back up a little, underwriting is the process by which a borrower’s credit score, background, and finances are examined to determine what level of credit risk they present, how much mortgage they can qualify for, and what their monthly DTI is calculated at. DTI is determined by comparing the borrower’s monthly debt payment obligations to his or her monthly income. To put it another way, DTI is how much money you have coming in each month compared to how much money you spend on bills and debts each month, expressed as a percentage.
>> Read More: Tips for Homebuyers With Student Debt
In the past, borrowers on IDR plans were allowed to use the monthly repayment amount under those plans to calculate their DTI, but no longer. Now, to qualify for a mortgage which will eventually be sold to Fannie Mae or Freddie Mac, the DTI calculation must use either 1% of the borrower’s balance as the monthly student loan payment, or use an actual payment amount that is fully amortizing (meaning by the end of the loan term all principal will be paid off). The problem is many graduates, and especially those coming out of expensive professional programs, cannot qualify for a mortgage on paper if the 1% rule is used. And their IDR payments cannot be used because IDR payments are typically not fully amortizing. Those borrowers are left with very limited options to obtain a home loan.
For example, many law students graduate with between $200-300,000 of debt in student loans. Despite public perception, the vast majority of lawyers fresh out of school will only make around $60,000 in their first jobs. And many law graduates who choose to work in public service fields, such as those who take jobs at legal aid clinics, might make as little as $45,000 a year or less. Even with no other debt to speak of – no monthly credit card payments or auto loan – a lawyer with $200,000 in student debt who makes $45,000 a year cannot obtain a mortgage under the new underwriting guidelines. While his or her actual IDR payment might be $100 a month, on paper and using the 1% rule it will appear as if the borrower’s monthly student loan payment is $2,000 a month! With a monthly income of only $3,750, approval is impossible.
Alarmingly, most other major purchases of mortgages – such as Wells Fargo and JPMorgan Chase – have changed their guidelines to match Fannie Mae and Freddie Mac’s. So, what is a college graduate with a high loan balance and low salary to do? Graduates in this position have limited options, but they can seek out smaller mortgage originators, such as local mortgage companies and credit unions, and ask them if they service any of their own loans.
A mortgage originator that services its own loans does not sell those loans to the big investors, and they can choose to ignore the 1% rule and run a DTI calculation based upon the borrower’s actual student loan payment under IDR. And married borrowers can attempt to find mortgages where the spouse with high student loan debt is left off the loan, so that the DTI can be calculated using only one spouse’s student loan debt. However, this also means that the first spouse’s income cannot be used to qualify for the loan, which will lead to a smaller approved mortgage amount based off of solely the second spouse’s income.
The changing underwriting guidelines have come as a shock to many graduates who counted upon qualifying for a mortgage based upon IDR repayment plans. All hope is not lost, however. Unless or until the guidelines relax again, these borrowers can still obtain mortgages by seeking out smaller mortgage originators. This new financial difficulty facing borrowers is yet another reason to minimize reliance upon student loans while in college.
Author: Jeff Gitlen
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