Many of the 44.7 million Americans with student loan debt are also in their prime homebuying years. And more than 8 million of them use income-driven repayment (IDR) plans for their student loans, which require special calculations for determining mortgage lending.

However, the three different government agencies and the two government-sponsored enterprises each use a different way of accounting for IDR plans when underwriting mortgages. This is confusing to borrowers and has disadvantaged some potential first-time homebuyers. The programs should be aligned to the fairest and most logical standard for addressing IDR plans.

The importance of student loan debt to mortgage borrowing

In determining whether to issue a mortgage and what type of mortgage to issue to a borrower, mortgage underwriters look at the borrower’s debt-to-income ratio (DTI), the ratio of a borrower’s debt service payments (monthly obligations to repay debt, including interest and principal) to their income.

Student loan payments—along with payments on other debt—are factored into this DTI ratio, which is then used, along with the borrower’s credit score and the loan-to-value ratio (the ratio of the loan amount to the market value of the property), to determine the borrower’s eligibility for a mortgage. Higher DTI ratios make it harder to get a mortgage or make a mortgage costlier to the borrower.

The challenge of income-driven repayment

About 30 percent of student loan borrowers currently in repayment on their loans use an IDR plan. The monthly payment on these plans is reset annually and is typically about 10 percent of the borrower’s income above 150 percent of the federal poverty level. (Borrowers with incomes below this threshold make a $0 payment.)

Unfortunately, the five federal institutions that back two-thirds of mortgage originations in the US—Fannie Mae, Freddie Mac, the US Department of Veteran’s Affairs (VA), the Federal Housing Administration (FHA), and the US Department of Agriculture (USDA)—have developed five different ways of taking these IDR plans into account in their underwriting.

These divergent methodologies create confusion and inconsistency and can disadvantage borrowers who end up with an FHA, VA, or USDA mortgage.

When the borrower has a fixed, standard loan payment, that monthly payment amount is generally used as part of the DTI calculation. But if the loan payment is variable for any reason, like it is with IDR, the way the loan payment affects the DTI ratio varies by agency:

• Fannie Mae generally uses the monthly IDR payment, even if it is $0.

• Freddie Mac’s policy is to use the monthly IDR payment, unless that payment is $0, in which case, Freddie uses 0.5 percent of the loan balance per month (e.g., $125 per month on a $25,000 loan).

• The FHA and USDA ignore the IDR payment amount entirely, assuming a payment of 1 percent ($250 per month on a $25,000 balance).

• The VA gives lenders the option of using the IDR payment amount or using 5 percent of the outstanding balance per year ($104.17 per month on a $25,000 loan).

In short, Fannie Mae always takes the actual IDR amount into account when calculating DTI ratios; Freddie does so, except when the payment is $0; the FHA and USDA do not take the actual IDR amount into account; and the VA leaves it up to the lender.

Many borrowers who can’t afford to make full payments on their student loans are still good candidates for mortgages

Many people with strong incomes qualify for IDR plans because they have a large amount of student loan debt. Consider a family with two children that earns $75,000 a year, with $100,000 of student loan debt. Although this debt is higher than typical, it can be generated by a married couple who each borrowed $30,000 for college, with one who borrowed an additional $40,000 for a master’s degree.

Under a standard repayment plan, they would pay about $1,000 per month for their student loans, but under the Revised Pay As You Earn (REPAYE) IDR plan, they would pay just $303 per month.

If they use REPAYE and apply for a mortgage guaranteed by Fannie Mae, the $303 per month payment will be fully taken into account, and the student loan contribution to the DTI ratio will be 4.8 percent.

If, instead, they apply for a mortgage insured by the FHA, the monthly payment under IDR will not be taken into account, and the student loans’ contribution to the DTI ratio will be 16 percent. This 11.2 percentage point difference in their DTI ratio could mean the difference between qualifying and not qualifying for a mortgage.

Young, nondefaulted student loan borrowers are more likely to use IDR and programs with harsh IDR treatment

About 24 percent of people ages 25–34 and 20 percent of people ages 35–49 with nondefaulted student loans rely on IDR (see figure below). Older borrowers are less likely to use IDR. First-time homebuyers comprise 79 percent of FHA purchase loans, 84 percent of USDA loans, and 54 percent of VA loans, but just 42–45 percent of government-sponsored enterprise loans.

Thus, the programs that many young IDR borrowers are more likely to use for their mortgages—the FHA, and, to a lesser extent, the USDA—are also the programs that put IDR borrowers at the biggest disadvantage.

The standard should be the same throughout the federal government underwriters

All five government institutions should use the same standard for accounting for IDR when underwriting mortgages, a standard that makes the most sense from an underwriting standpoint. The most logical way is to allow the DTI ratio to “count” only the actual amount paid.

There are two reasons for this:

• First, mortgage underwriting assesses only actual income, not income earning potential. If someone is on the steep part of their earnings curve, the potential earnings are not considered.

• Similarly, only actual debt service payments should be considered, not potential payments. Moreover, the borrower’s IDR payments will increase only when their income increases, giving the borrowers more capacity to repay a mortgage.

Consistency across the five government institutions in taking IDR into account will ensure that no borrower will be disadvantaged simply because of the program they choose for their mortgage.