In this post, we are going to
look further at the connection between student loans and mortgages –
particularly conforming loans that are guaranteed by Fannie Mae and Freddie
Mac. Navigating the interwoven world of
government subsidized finance can be difficult and, at times, totally mind
bending, as the government often times contradicts or deceives its own
underwriting standards. One such example
of this is the treatment of student loans by Fannie and Freddie. In the following, we are going to examine how
the next-generation of homeowners can use student loan refinancing in order to
receive much better treatment from Fannie and Freddie.
Fannie Mae was created in 1938 as
part of the New Deal. Fannie existed as
a government agency until the 1960’s, at which point it was partially
privatized with an “implicit” guarantee from the US Treasury. Freddie Mac, Fannie’s identical twin, was
created at this same time to provide adequate competition to Fannie Mae. Both Fannie and Freddie collapsed with the
housing crisis in 2008 and were subsequently re-absorbed by the government
after a substantial taxpayer bailout.
The entities exist today in an awkward limbo: they are still private
companies but are essentially 100% owned by the government with a direct line
of credit to the US Treasury. One might
wonder why these entities continue to exist in this convoluted structure. The simplest answer is: keeping them as a GSE
under an “implicit” guarantee allows Congress to forego accounting for the
liabilities of Fannie and Freddie as part of its budget and debt calculations.
Despite their messy ownership
structure, Fannie and Freddie still perform the same basic function they did
before 2008: they buy “conforming” mortgages from local banks, guarantee the
mortgage payments and then re-sell the packaged loans as mortgage backed
securities (MBS) to global investors. This
process allows local banks to originate mortgages and then sell them to
Fannie/Freddie for cash, which allows those same banks to then make new loans
to more borrowers. In today’s market,
90% of all mortgages are sold to either Fannie or Freddie. This means that essentially all mortgages
today are underwritten according to Fannie/Freddie’s definition of “conforming
loans.”
The definition of a conforming
loan is the single most important delineation in the American consumer
financial market. It is also one of the
most rudimentary and unsophisticated. There
are essentially four criteria that Fannie/Freddie use to determine the status
of a potential mortgage borrower:
- Loan to Value (LTV): the ratio of the mortgage amount to the appraised value of the property;
- Credit Score: middle score from the three credit bureaus;
- Debt-to-Income (DTI): the ratio of monthly debt payments to monthly gross income;
- Minimum Reserve Requirement: required number of monthly payments a borrower must have as a reserve of liquid assets
We are particularly interested in
the DTI criteria. The table above is the
“eligibility matrix” for Fannie Mae, which delineates the qualifications for a
conforming loan. As shown, the maximum
DTI at which a borrower can qualify for a conforming loan is 45%; and, there
are several other delineations that restrict borrowing limits if DTI is above
36%. This is important because DTI is
calculated as the ratio of monthly income to monthly obligations, including
both proposed mortgage payments and
existing installment debts, including student loans. As a result, recent graduates who are paying
too much on their existing student loans will also have more difficulty in
obtaining government mortgages.
Fortunately, there is a simple solution: refinance with Prime Student
Loan.
To illustrate this point, let’s
look at what that calculation might look like.
Let’s assume that a borrower is buying a single family home for $300,000
and is looking to obtain a 95% LTV mortgage for $285,000. Let’s further assume that the borrower is a
recent college graduate with $80,000 in student loan debt, gross annual income
of $60,000, and a FICO score of 720. We
can then calculate their DTI under their current student loan portfolio and a
post-refinancing portfolio. The results
are shown below left.
As one can see, under their
current student loan repayment strategy, this borrower would not qualify for a
conforming loan with the current terms.
The borrower would have to either reduce the loan amount (increase the
down payment) or lower their offering price.
Alternatively, if the borrower refinanced their existing student loans
into a lower rate and longer term, they would simultaneously reduce their DTI,
as calculated by Fannie and Freddie.
Under this new refinancing strategy, this borrower would be approved for
the mortgage and on their way to home ownership!
At PSL, we are constantly
imploring student loan borrowers to capitalize on refinancing opportunities in
order to lower their monthly payments and maximize their financial flexibility. While this financial flexibility might seem
unnecessary to some borrowers, it is my hope that this example helps illuminate
why that flexibility is so valuable. In
addition to obtaining better mortgage opportunities, I would note that FICO
scores include a similar DTI calculation, as do auto loans and credit
cards. So, in conclusion, if you are
thinking about buying a home, buying a car or taking out a new credit card,
then you could be greatly harming yourself if you do not look into student loan
refinancing before you solicit other forms of consumer debt.
No comments:
Post a Comment