There’s a new study by Federal Reserve researchers quantifying something many Realtors already know from experience: Excessive debt-to-income ratios account for nearly a quarter of all mortgage denials.
In “Residential Mortgage Lending from 2004 to 2015: Evidence from the Home Mortgage Disclosure Act Data,” Neil Bhutta and Daniel R. Ringo detail how monthly payments on everything from student loans to credit cards and car payments often push would-be homebuyers’ DTIs beyond the maximum limits set by Fannie Mae , Freddie Mac and FHA.
Yet an estimated 1 million homebuyers with student loan debt will go to the closing table in 2017. The National Association of Realtors reports that even though millennials are loaded down with student loan debt, many are able to become homeowners by buying smaller, older and cheaper homes.
They’re also making smaller down payments, sometimes with help from their parents or state housing finance agencies. Some of these state programs are specifically targeted at student loan borrowers and recent graduates.
A hidden issue with student loans
Another issue that has largely flown under the radar is how mortgage lenders treat the DTI calculation for student loan borrowers who are enrolled in one of the government’s income-driven repayment plans.
IDR plans cap the borrower’s monthly student loan payments at a percentage of their disposable monthly income, typically 10 or 15 percent. More than 5.3 million borrowers are paying back $353 billion in IDR plans, The Washington Post reports.
While IDR plans can help ease the financial stress of paying down student loan debt, there’s a catch for borrowers who want to become homebuyers: If the monthly payment borrowers make in an IDR plan aren’t big enough to fully amortize their student loans, Fannie Mae and FHA will not accept that payment for purposes of calculating DTI.
Fannie Mae, for example, expects lenders to either calculate a payment that will fully amortize the borrower’s student loans, or simply use 1 percent of the outstanding balance.
A borrower with an adjusted gross income of $50,000 who has consolidated $49,000 in student loan debt at 6.8 percent interest and is paying it down in an income-driven repayment plan would start out with a $268 monthly payment (you can use the Department of Education’s repayment estimator to run your own numbers).
The monthly payment required to fully amortize that loan based on the 25-year term specified by Fannie Mae would be $340. Alternately, plugging 1 percent of the loan balance into the DTI formula would be $490 a month. Either way, you’re looking at a much bigger impact on the borrower’s DTI than the $268 monthly payment they might have been hoping would be used to calculate DTI.
FHA has similar requirements for calculating the impact of student loan payments on DTI.
Freddie Mac tells us that while they do not require that the monthly student loan payment in an IDR plan be fully amortizing, they do expect the lender to take into account whether the payment might increase in the future. So if you’re paying down student loans and in the market to buy a home, your best bet might be to work with a lender who can qualify you using Freddie Mac’s guidelines.
Another approach to tackling DTI
Another way borrowers can reduce the monthly payment on their student loans is to refinance them at a lower interest rate. Since monthly payments on refinanced student loan debt are fully amortizing, they meet Fannie, Freddie and FHA requirements for plugging them into DTI calculations.
Borrowers who have used Credible.com to refinance into a loan with a longer loan repayment term saw rate reductions averaging 1.36 percentage points, and reduced their student loan payments by $218 a month (disclosure: I’m the founder and CEO of Credible). A homebuyer who prequalifies for a $300,000 home loan and then trims $218 from their monthly student loan payment could boost their mortgage borrowing limit to $350,000.
Refinancing student loan debt is not for everyone. Borrowers who refinance federal student loans with a private lender lose benefits like access to income-driven repayment programs and the potential to qualify for loan forgiveness after 10, 20, or 25 years. But thousands of borrowers have decided the savings they can achieve by refinancing are worth forgoing those benefits.
Stephen Dash is the founder of Credible.com, a marketplace for student loans and student loan refinancing that lets borrowers request personalized rates and compare options with vetted lenders.
Article originally posted on Forbes.com