UPDATED: 7/16/2016 – Student loans and mortgage qualifying are indeed a hot topic. Since first posting this article in March 2016 both FHA and Fannie Mae have made significant changes to their treatment of Income Based Repayment student loans.
Some of the changes will help those with IBR student loans while others most certainly will not. Updates are highlighted in RED.
If you have questions about your specific situation and potential options, comment in the thread at the end of the article and I’ll do my best to get you the answers you need.
As more Millennial’s are looking to buy their first home, many are faced with the challenge of student loan debt and how lenders calculate payments when determining debt to income ratios. Unlike other types of debt that include monthly payments of principal and interest, student loans often have reduced or deferred payments that do not include principal repayment.
Specifically, Income Based Repayment (IBR) plans limit your federal student loan payments to a percentage of your income. These plans can go a long way towards making payments manageable for young professionals just entering the workforce at entry level salaries. For those with very low income, payments can be as little as $0.
This is where things get interesting for mortgage lenders seeking to make sound underwriting decisions. Should they calculate debt to income ratios using the payment set under the IBR plan? Or, since the payments must eventually rise if the loan is ever to be paid off, should they use some type of proxy for a fully amortizing payment?
The answer depends on the type of mortgage you are applying for. Since the vast majority of borrowers with student loan debt aren’t looking at Jumbo loans, we’re going to focus on the different ways Fannie Mae, Freddie Mac, FHA, VA and USDA answer this question.
If you love details, you can read the entire guideline in italics. If you like to get right to the point, skip to the BOTTOM LINE in bold.
For all student loans, whether deferred, in forbearance, or in repayment (not deferred), the lender must include a monthly payment in the borrowers recurring monthly debt obligation when qualifying the borrower.
The lender must use one of the options below to determine the repayment amount:
The ‘current prevailing student loan interest rate’ can be found on a variety of websites. For example. see U.S. Department of Education Federal Student Aid in E-1-03. List of Contacts.
The following table specifies the repayment period to be used when calculating a fully amortizing payment.
Calculating a Student Loan Repayment
|Total outstanding balance of all student loans||Repayment Period|
|$1— $7.499||10 years|
|$7.500 — $9.999||12 years|
|$10.000 — $19,999||15 years|
|$20.000 —$39.999||20 years|
|$40.000 — $59.999||25 years|
|$60,000 +||30 years|
Note: The lender is responsible for determining that the payment on the credit report or other documents provided by the student loan lender or borrower are fully amortizing payments.
Example: Calculating an Amortizing
Payment Balance: $17.500
Repayment period: 15 years
Interest rate: 4.29%
Monthly Amortizing Payment: $132.00
Use 1% of the outstanding student loan balance. Use the actual amortizing payment. If you are unable to document the actual amortizing payment, use the calculated payment using the method above as it will nearly ALWAYS be less than 1% of the balance. If ALL ELSE FAILS, use 1% of the outstanding balance.
When a monthly payment on an installment debt is not reported on the credit report or is listed as deferred, the Seller must obtain documentation verifying the monthly payment amount included in the monthly debt payment-to-income ratio. If no monthly payment is reported on a student loan that is deferred or is in forbearance, and there is no documentation in the Mortgage file indicating the proposed monthly payment amount (e.g., the loan verification letter), 1% of the outstanding balance will be considered to be the monthly amount for qualifying purposes.
Examples of documentation of the required payment amount include:
While the Freddie Mac seller guide has not changed since the publishing of this article, we have spoken directly to Freddie Mac and received confirmation that they will in fact use the IBR payment when calculating debt to income ratios.
Use 1% of the outstanding student loan balance. Use the documented IBR payment as long as it is greater than zero. For any loans with no payment, including IBR loans, the lender must fall back to the forbearance guidelines and use 1% of the outstanding balance unless you are able to provide documentation verifying the proposed monthly payments will be less than 1%.
FHA 4000.1 Section II. A. 4. B. (H)
(4) Calculation of Monthly Obligation
Regardless of the payment status, the Mortgagee must use either:
Use the required payment under the income based repayment plan! Unless you are able to provide documentation from your lender showing the actual payment that would amortize your loan in full over a fixed loan term is less than 1% of the balance, the lender will use 1% of your outstanding loan balance as the payment.
Student Loans (1/4/2016)
Standard Repayment Plan: The required monthly payment is to be used for qualification purposes.
Income Based Repayment Plan: Use the current payment as shown on the income based repayment agreement, or credit report for qualification purposes.
Graduated Repayment Plan-Graduated Payments: Use the payment that will be in effect three (3) years from the Note Date for qualification purposes.
If a monthly payment is not reflected on the credit report or there is need for the payment amount required for qualification purposes, documentation, as evidenced by a letter from creditor or repayment schedule, is required to verify monthly payment.
BOTTOM LINE: Use the required payment under the income based repayment plan!
If the borrower has a student loan with an income based repayment, you must use 1% of the balance. Below you will find the guideline directly from the USDA underwriting manual:
Student loans. Lenders must include the greater of
Income Based Repayment (IBR) plans; graduated plans, adjustable rates, interest only and deferred plans are examples of repayment plans that are subject to change and do not represent a fixed payment or repayment plan. These types of repayment plans are unacceptable to represent a long term fixed payment repayment plan.
VA and USDA loans are both limited. Unless you are a veteran or buying in a “rural” area as defined by the USDA, these loans aren’t an option. If they are, the good news is both have straightforward, borrower friendly treatment of IBR plans.
For most people, the question will come down to which programs you qualify for and then which offers the most favorable income based repayment calculation. If you need to use FHA due to lower credit scores or higher debt to income ratios, things just got a lot tougher.
After offering guidance earlier this year allowing the use of IBR payments, the current guidelines require documentation of the actual amortizing payment or 1% of the outstanding balance will be used. In either case, the payment used for qualifying will be higher than the current IBR payment. If your loan balance is relatively large, this treatment will likely erase much, if not all, of the benefit of FHA’s higher debt to income ratios.
If you are able to qualify using Fannie Mae or Freddie Mac programs, you have a good bit more flexibility. In most cases, a borrower that can be approved through Fannie Mae’s automated underwriting system (AUS) will also be approved through Freddie Mac’s AUS. This is great news if you have an IBR payment that is greater than zero. Freddie will use the IBR payment reported on the credit report so you should be home free.
If you are working with a lender that ONLY offers loans underwritten to Fannie Mae guidelines OR you have an IBR payment of $0, Fannie has an option that will not be as bad as using 1% of the balance.
Let’s look at an actual scenario for a borrower I’m working with right now.
She’s looking to buy a home for $350,000. Her income is just over $72,000 per year. She just went through the annual review on her IBR plan and for the next 12 months she pays $146 a month on roughly $117,000 of student loan debt. If you’ve been paying attention up to this point, you see where this is going.
Since she has good credit and her debt to income ratios are under 45% using the IBR payment, we’re in luck. We can use Freddie Mac guidelines and pull the $146/month from the credit report and she’s good to go.
WHAT IF, her IBR payment had been set at zero? In that case, we could look at going FHA. Under current guidelines we simply use 1% of the $117,000 loan balance as the monthly payment. The bad news is this pushes us over the maximum FHA debt to income ratio of 56.9%. That doesn’t work so let’s move on to Fannie Mae.
Assuming her lender would not give us documentation of a fully amortizing payment AND her loan documentation doesn’t provide enough information for us to calculate the amortizing payment, we have to use the calculated method using the ‘current prevailing student loan interest rate’.
Using the chart above we see that we use a 30 year term and the current prevailing interest rate is 4.29%. That leaves us with a monthly payment of $578. Even though the calculated payment is much higher than the actual IBR payment, we can keep the debt to income ratio just under the maximum 45% and approve the loan.
The bottom line is, “it’s complicated.” But there are options and if you’re working with an experienced loan officer who understands the intricacies of student loan qualifying guidelines, there should be an option for you. As always, we’re here to help. If you have any questions, or specific scenarios reach out directly or in the comments section below.