By: Victor Normand
Last month we discussed the very large problem of ever increasing student debt and its effects on first time home buyers. It’s clear that something needs to be done to bring higher education costs down and at the same time introduce some form of underwriting into the process of qualifying for a student loan. While there are differences between the sub-prime lending crisis and a student debt crisis, there are dangerous similarities as well.
In the meantime, there are many individuals and families who would otherwise be active in the housing marketplace but for the need to manage student debt. For good or bad, the debt is there and often perceived as an insurmountable barrier to home ownership. But there are options for those willing to seek them out.
For some, paying off college loans is paramount, and delaying home ownership and even marriage and starting a family will just have to wait. But the standard term of college loans, (10 years) is a long time to wait before the debt to income (DTI) ratios will be good enough to allow for a mortgage. Then there is the matter of a down payment and how that happens when there is no discretionary income.
The alternative for many with student debt is Income Based Repayment (IBR). This option is available to those with federal student loans, which is more than 75% of the $1.4 trillion in outstanding loans. These programs extend the repayment period for qualified borrowers to as long as 25 years. As you can imagine, the amount of interest paid under these programs relative to the original debt is substantial.
Qualifying for these programs involves calculating “discretionary income” which is the difference between adjusted gross income and 150% of the annual poverty line based on family size. Depending on when the loans were taken out, monthly payments are either 10% or 15% of that amount. A recent graduate with $60,000 of student debt who earns $40,000 annually could see their monthly payment decreased from $650 to as low as $180. There are many variables associated with IBR programs, but such decreases are not uncommon.
With discipline, someone taking advantage of an IBR could accumulate the cash needed for a down payment on a modest house or condominium. Making payments on time under an IBR program should reflect just as well on a credit score as payments under the original repayment plan. Loan underwriters and some of the Government Sponsored Enterprises (GSE’s) however do not look favorably on IBR plans.
Presently, some conventional lenders, FHA and USDA programs consider an IBR a temporary deferral and require underwriting to use the original loan terms or 1% of the loan balance, whichever is lower, to qualify a borrower. All IBR programs require annual re-certification, but they remain in place for as long as discretional income remains low and the borrower wants to participate. Fannie Mae and Freddie Mac will use IBR plans to meet their loan standards.
An added feature to some IBR programs is loan forgiveness. A graduate with high debt who is employed in a low paying profession, will have any balance remaining on their debt, forgiven at the end of the 20 or 25-year term. This may have tax consequences for the borrower, but it is something to consider. Of course, higher incomes than expected can always be used to pay down or pay off student loan debt at any time. And with home ownership, comes opportunities to use accumulated equity to pay down debt at lower rates of interest and greater tax deductibility options than student loan debt.
In conclusion, if those with student debt have a tolerance for making very high interest payments, especially during the early years of repayment, are willing to spend the time to learn more about the benefits and drawbacks of the IBR program and inclined to seek out a lender familiar with IBR, home ownership might just happen.