Mortgage giant Freddie Mac is following in the footsteps of its big sister Fannie Mae and adopting new rules for evaluating the creditworthiness of millions of student loan borrowers who want to become homeowners.
That’s big news, since Fannie and Freddie remain a major force in mortgage markets, purchasing or guaranteeing nearly half of U.S. home loans.
The first important development this year came in April, when Fannie Mae announced that it would allow mortgage lenders to be more flexible in evaluating how much additional debt homebuyers with student loan debt can safely take on.
In many cases, Fannie’s new rules not only better the odds that borrowers with student loan debt will be approved for a mortgage, but allow them to take out bigger loans than was previously the case (more on that below).
With prices soaring in many housing markets, that additional buying power could help many millennials with student loan debt make the move from renter to homeowner.
Now Freddie Mac says it’s updating its own rules for calculating the debt-to-income (DTI) ratios of borrowers who are paying back student loans.
DTI ratios — which measure how much of your monthly income is eaten up by the payments you make on everything from student loans to credit cards and car payments– are a crucial metric for lenders. If your monthly student loan payment and other expenses are putting a strain your income, your DTI will probably exceed the maximum limits set by all of three of the biggest players in mortgage finance — Fannie Mae, Freddie Mac and FHA.
Fannie and Freddie have historically wanted to see borrowers maintain a DTI of 36 percent or less, but routinely approve borrowers with DTIs of up to 45 percent and will go to 50 percent in special cases where borrowers can document “compensating factors” such as a stockpile of cash reserves or other assets.
At the end of July, Fannie started considering loan applications with DTIs of up to 50 percent without requiring borrowers to document compensating factors. This is a major development that applies to all homebuyers, not just those with student loan debt. In other words, a homebuyer with $8,000 in monthly income could have $4,000 in monthly bills and still qualify for a Fannie Mae mortgage — $400 more than under the old 45 percent DTI limit.
Analysts with the Urban Institute’s Housing Finance Policy Center estimate that Fannie Mae’s higher DTI limits could generate an additional 95,000 new mortgage approvals a year, with a “disproportionate share” of those loans likely to be taken out by black and Latino families, who are 1.5 times as likely to have DTI ratios above 45 percent.
(Although it’s not publicized it, Freddie Mac has “been quietly accepting loans” with 50 percent DTI ratios for the past six years, according to Mike Vitali, senior vice president and chief compliance officer for LoanLogics. The Urban Institute’s Housing Policy Finance Center estimates that about 7.8 percent of borrowers taking out mortgages purchased or guaranteed by Freddie Mac from 2010-16 had DTIs above 45 percent. That compares to 4.6 percent of mortgages purchased by Fannie Mae during the same period).
FHA-backed mortgages, which carry smaller down payments and are popular with younger homebuyers, are easier to qualify for if your DTI is 43 percent or less. But FHA will insure mortgages with DTIs of up to 50 percent when borrowers can document compensating factors — that they have healthy cash reserves, for instance, or that the monthly housing payment they’re already making won’t increase by much.
Although Freddie’s new rules for calculating DTI are somewhat more restrictive for some borrowers than its existing policy, they still give special consideration to borrowers paying back student loans in income-driven repayment (IDR) plans.
IDR plans challenge mortgage lenders
Fannie and Freddie’s new rules are of special importance to borrowers who are enrolled in income-driven repayment (IDR) plans, which tie monthly student loan payments to discretionary income.
The plans have proved popular with student loan borrowers — more than 7 million had signed up to repay $359 billion in federal student loans through one of these plans as of June 30. But IDR plans present a challenge for mortgage lenders, who are required to assess how much debt homebuyers can afford to take on before approving them for a loan.
Borrowers making monthly student loan payments in IDR pans like PAYE or REPAYE don’t have to pay more than 10 or 15 percent of their discretionary income. That can make monthly student loan payments much more manageable — if you have no discretionary income, your monthly payment is zero.
But IDR plans may also stretch your payments out over a much longer period of time. Luckily, if you haven’t paid off your student loans after 20 or 25 years in an IDR plan, the remaining balance can be forgiven (although whatever amount is forgiven is considered taxable income by the IRS).
In many cases, the payments borrowers make in an IDR plan aren’t even enough to cover the interest they owe. Their student loans are “negatively amortizing” — the balance owed is getting bigger, rather than shrinking over time.
For mortgage lenders, that growing debt obligation represents a potential “payment shock.” If a borrower’s income increases — or if they’re kicked out of an IDR plan for failing to recertify their income — their monthly student loan payment may increase dramatically. That could mean less money is available to pay their mortgage.
Until recently, if the monthly payments student loan borrowers were making in an IDR plan weren’t big enough to pay off their debt in 25 years, Fannie Mae would not allow mortgage lenders to rely on that payment in calculating debt-to-income (DTI) ratio.
Fannie expected lenders to either calculate DTI using a monthly payment would fully amortize the borrower’s student loans, or use an amount equal to 1 percent of the outstanding balance.
So if a hypothetical borrower with $49,000 in student loan debt was making making payments of $266 a month in an IDR plan, Fannie would require the lender to assume that those payments were $340 a month (the amount payment required to pay that loan off in 25 years) or $490 a month (1 percent of the loan balance) for the purposes of calculating DTI.
Plugging those higher monthly payments into the DTI calculation would often result in borrowers being turned down for a mortgage, or getting approved for a smaller loan.
Fannie and Freddie’s new rules
In April, Fannie announced new guidelines that allow mortgage lenders to use the borrower’s actual monthly student loan payments to calculate DTI — even they’re enrolled in an IDR program and their payments are zero or don’t cover the interest they owe.
On Oct. 18, Freddie Mac issued special guidance for calculating the debt-to-income ratios of student loan borrowers that, while not as generous as Fannie’s new rules, do make accommodations for borrowers in IDR plans.
Currently, Freddie will allow lenders to use a non-amortizing monthly student loan payment to calculate DTI. But lenders must obtain documentation verifying that monthly payment if it’s not in the borrower’s credit report.
Starting Jan. 18, lenders must use the monthly payment on the borrower’s credit report, or 0.5 percent of the original or outstanding loan balance — whichever is greater (lenders are also free to adopt the rules now, if they choose).
So for that hypothetical borrower with $49,000 in student loan debt making making payments of $266 a month in an IDR plan, Freddie would allow the lender to use that payment to calculate DTI. That’s because the actual monthly payment exceeds 0.5 percent of the loan balance — in this case, $245. But if your IDR plan allowed you to make a monthly payment of $110 on $49,000 in student loan debt, the lender would have to pretend that your mortgage payment was $245.
That’s still more generous than Fannie Mae’s old policy, which would have required the lender to assume that the borrower was paying $340 a month (the amount payment required to pay the loan off in 25 years) or $490 a month (1 percent of the loan balance).
The thinking behind Freddie’s slightly more restrictive rules is that borrowers who are enrolled in IDR plans may see their payments increase as their income rises — they must “recertify” their earnings once a year.
“By requiring the use of a minimum payment of 0.5 percent of the original loan balance or outstanding balance, whichever is greater, the risk of the potential payment shock from the monthly payment increasing after the annual recertification is reduced,” Freddie Mac said in its guidance to lenders. “However, the borrower is still given the benefit of using a lower monthly payment amount than would be required under the traditional fully amortizing repayment plan.”
However, Freddie Mac is making life a little easier for lenders and homebuyers alike, by removing the requirement that lenders obtain documentation if the amount of the borrower’s monthly student loan payment doesn’t show up on their credit report.
For borrowers who are expecting their loans to be forgiven in the next 10 months through Public Service Loan Forgiveness or Teacher Loan Forgiveness, Freddie says lenders can disregard monthly student loan payments from the DTI ratio calculation altogether.
Qualifying for a bigger mortgage
One way to get a feel for how your monthly student loan payment affects DTI — and your home buying power — is to take any reduction in monthly student loan payment that can be achieved, and apply that amount to a mortgage payment instead.
Let’s say that hypothetical borrower who was paying $266 a month on $49,000 in student loan debt in an IDR plan was also able to qualify to buy a $300,000 home with a 5 percent down payment. At today’s interest rates, their monthly mortgage payments would be $1,354 a month.
Before Fannie Mae adopted its new rules for calculating DTI, the mortgage lender would have been required to assume that our hypothetical borrower was paying $340 a month on their student loans (that’s the amount required to “fully amortize” the loan and pay it back in 25 years).
Fannie Mae’s new policy lets the mortgage lender use the borrower’s actual student loan payment of $266 a month to calculate DTI. That, in turn, gives the borrower the capactiy to make an additional $74 a month in mortgage payments — without affecting their DTI.
In this case, the $1,428-a-month mortgage payment translates into roughly $18,000 in additional home buying power — a welcome boost if you’re competing in a bidding war.
Another way to reduce your monthly student loan payments is to adjust your interest rate or repayment term (or both) through refinancing.
According an analysis of borrowers refinancing student loan debt through the Credible marketplace, those who refinance into a loan with a longer term lower their monthly payment by $218, average.
At today’s interest rates, a borrower who prequalified to buy a $300,000 home with 5 percent down could boost their home buying power to about $350,000 if their student loan payment was reduced by $218 a month.
Other tips for homebuyers with student loan debt
According to a recent survey by the National Association of Realtors, most millennials with student loan debt say it’s affecting their ability to buy a home, delaying their plans by a median of 7 years.
Of course, not everyone wants to own a home. But 63 percent of those surveyed said that if they didn’t have student loan debt, they’d be putting some of that additional money aside for a down payment.
While student loan debt can definitely get in the way of buying a home, NAR has also documented that, for the last four years, millennials have been buying more homes than members of any other generation, accounting for more than one in three home sales.
When mortgage data aggregator Black Knight Financial Services analyzed the numbers in 2016, it turned out that 7.7 million people with mortgages also had student loan debt, a 40 percent increase over the past decade. Black Knight concluded that about one in four homebuyers who were approved for purchase mortgages in 2014 had student loan debt. That implies that about 1 million homebuyers with student loan debt go to the closing table every year.
All of which suggests that student loan debt isn’t as big a hurdle to home ownership as some might think. One issue for student loan borrowers who haven’t bought a home is saving for a down payment. Many may be under the impression that they’ll need to make a down payment equal to 20 percent of their home’s purchase price.
But many mortgage programs allow buyers to get into a home with little or no money down, and a number of state housing finance agencies offer down payment assistance to homebuyers — some of these programs are targeted specifically at student loan borrowers.
If you make a down payment of less than 20 percent, you can expect to pay extra for private mortgage insurance or FHA insurance premiums. Another drawback with making a small down payment is that, the less equity you have in your own home, the more likely you are to lose it to foreclosure if you’re unable to make your mortgage payments.
Maintaining a comfortable equity cushion can also be an issue for existing homeowners who want to roll their student loan debt into their mortgage — Fannie Mae’s Student Loan Cash-Out Refinance is one avenue for paying off high-interest student loans. Although anyone who’s eligible for a cash-out mortgage refinance can use the proceeds to pay off debt, Fannie’s program can make such a move more attractive, since it waives some costly fees when you pay off one or more student loans in their entirety.
While it’s great that student loan borrowers are getting more leeway to become homeowners, it’s important to take careful measurement of your own, unique circumstances before acting.