On a regular basis, my clients reach out because they want to buy a home but run into trouble getting approved for a mortgage because of their student loans. I also teach mortgage brokers around the country how to use the strategies below to get their borrowers with student debt through underwriting.
When you see a lender to get approved for a mortgage, your success hinges on something called the Debt to Income Ratio (DTI). This is the amount of money you bring in through income versus how much goes out in monthly expenses. The better your DTI - meaning the more money you have left over at the end of the month - the more likely you will be approved for a mortgage, and the more money they will lend you to purchase a home.
Most mortgage brokers and lenders believe they must use what is called “The 1% Rule” when calculating your student loan monthly payments toward your monthly expense.
Here’s what that means. Let’s say you bring your financials into the office, and the mortgage broker sees a student loan for $200,000. They immediately think they have to put $2,000 per month in the expense column, regardless of what you actually pay.
It then becomes our mission to get the payment they show on your paperwork below the 1% rule in a way that the underwriters will approve of.
I have found two ways to get under the 1% rule, regardless of which mortgage company you choose. Even though all mortgage lenders have slightly different rules, they all follow the government guidelines. Why? To sell your loan on the secondary market, they must conform to the benchmarks that the government sets. If you understand that, and you can explain these solutions to the mortgage broker, the underwriters should accept the solutions. Also, keep in mind that not all mortgage brokers are created equal. Be prepared to explain this to them.
The two ways of getting under the 1% rule relate to the type of mortgage you want:
FHA or Conventional.
When you seek a loan under FHA, you need to know the two ways the lender can present your student loan debt to the underwriter. I will quote the FHA guidelines verbatim, so you don’t get confused:
Calculation of Monthly Obligation
Regardless of the payment status, the Mortgagee must use either:
-the greater of:
-1% of the outstanding balance of the loan
-the monthly payment reported on the Borrower’s Credit report; or
-the actual documented payment provided the payment will fully amortize the
loan over its term.
In plain English, that means you can use either 1) the Greater Of 1% of the balance or what’s on the credit report 2) OR a fully amortizing monthly payment.
“Fully amortizing” just means a payment that will eventually pay off the loan. Essentially, FHA doesn’t like Income-Driven Repayment and Forgiveness, and they need to see the loan being paid off mathematically.
Now that you know these rules, the strategy we use to get below the 1% rule (when it comes to FHA) relates to the fully amortizing payment. If you pay 1% of your total loan balance per month, you are in the 10-Year Standard Repayment Plan - the one everyone gets right out of school. What we would do is simply extend the length of the loan term. You can call your servicer and asked to be put on the Extended Fixed or the Extended Standard Repayment plan.
This will lower your monthly payment to usually about 65% of the original 1% 10-Year Standard Plan. So if you owe $50,000; then 1% would be $500 a month. Putting yourself on a 30-Year or even 25-Year fixed plan will drop your payment to roughly $325-$350 or so.
You might not think that’s a tremendous savings, but rest assured that every little bit helps when it comes to DTI.
When you seek a conventional loan, understand that roughly 75% of all conventional lenders use the Fannie Mae guidelines. Again, this is so they can sell your loan on the secondary market. The Fannie Mae guidelines used to be identical to the FHA guidelines.
Starting in 2008, in response to the mortgage meltdown, these rules created serious restrictions on borrowers. Suddenly, we collectively had to protect America from bad lending practices and actually make sure borrowers could afford their payments. But that eventually changed. Fannie Mae struggled to lend, because so many people with student loan debt kept getting denied. So they loosened the rules. As of September 2017, the guidelines were changed to the following:
If a monthly student loan payment is provided on the credit report, the lender may use that amount for qualifying purposes. If the credit report does not reflect the correct monthly payment, the lender may use the monthly payment that is on the student loan documentation (the most recent student loan statement) to qualify the borrower.
If the credit report does not provide a monthly payment for the student loan, or if the credit report shows $0 as the monthly payment, the lender must determine the qualifying monthly payment using one of the options below.
If the borrower is on an income-driven payment plan, the lender may obtain student loan documentation to verify the actual monthly payment is $0. The lender may then qualify the borrower with a $0 payment.
For deferred loans or loans in forbearance, the lender may calculate
a payment equal to 1% of the outstanding student loan balance (even if this amount is lower than the actual fully amortizing payment), or
a fully amortizing payment using the documented loan repayment terms.
Here’s what all of that jargon means. With a conventional loan, to get under the 1% rule and fully amortizing payment, you can use whatever is on your credit report or your monthly statement from the servicing company even if it is $0 a month. This option opens the door for Income-Driven Repayment because we can also use an approval letter for an IDR request at $0 a month or any payment amount.
Let’s walk through an example to illustrate:
If you owe $50,000, then 1% would be $500 a month. Putting yourself on a 30-year or 25-year fixed plan will drop your payment to roughly $325-$350 a month. But if we can use Income-Driven Repayment to lower your payment like with conventional to $50 a month, then that would free up an extra $450 a month toward your Debt to Income Ratio.
How long do these strategies take to complete? With either one, it takes roughly 30 days to set you up in the new repayment plan.
Once that’s done, you can take the new monthly statement to your mortgage broker and that should be enough to get through underwriting. The reason most mortgage brokers don’t know what I am telling you is because they have not kept up with the recent changes to the guidelines. To be fair, though, they probably haven’t obsessed over every line in the rules when it comes to student loans, like I have.
Keep in mind that both of these strategies exist only to help you obtain the mortgage. Once you close escrow on the home, you can switch your student loan repayment plan back to whatever you wish.