There were some rumblings of excitement among mortgage lenders last week when Fannie Mae announced changes to its underwriting guidance pertaining to deferred student debt. At closer inspection, the changes will benefit most student debt-laden borrowers, but not all.

Here’s the best news: The 2% Exception is dead. Under this rule, if a borrower’s deferred student debt payments were not sufficiently documented, then the underwriter had to assume a monthly debt obligation equal to 2% of the total outstanding principal debt. This is what you call a “deal killer”.

We discussed the 2% Exception in a previous blog post and urged lenders to take the steps necessary to help borrowers document their repayment terms so the 2% Exception could be avoided. In its Selling Guide Announcement (SEL-2014-16), Fannie Mae reports that “the actual monthly payments are typically lower than 2%.” And the report concludes, “Fannie Mae is modifying the monthly payment calculation from 2% to 1% of the outstanding balance,” effective immediately.

So the 2% rule is simply replaced with a 1% rule, correct? Well, not so fast.

The new formula promulgated by the Agency is that the lender must use the greater of 1% of the outstanding balance or the actual documented payment when determining the monthly debt obligation for deferred student loans. This is good news, though it might have the perverse effect of encouraging less documentation of deferred student debt repayment terms. For example, a borrower earning $50,000 with $50,000 in deferred student debt would apply the following formula:

a)      1% of UPB = $500

b)      Actual payment, Standard 10-Year Repayment Plan = $575

If fully documented, the monthly student debt obligation included in the debt-to-income (DTI) calculation would be $575, otherwise $500 would apply.

But what if the actual documented payment is less than 1% of the outstanding principal? The new rule states that the lower actual repayment amount may be used if the documented payment will fully amortize and there will be no payment adjustments. Relative to student debt repayment options, only the Standard and Extended Fixed repayment plans fully amortize and have no scheduled (or unscheduled) payment adjustments. In other words, if the borrower is on a Standard or Extended Fixed plan, and the payment is lower than the 1% calculation, then the lower payment may be used.

In the scenario below, C is the only eligible plan resulting in a payment lower than the 1% calculation. Plans D through F result in lower payments but they cannot be used because payment adjustments will occur (scheduled in the Graduated plan, and expected in the income-based plans.) Therefore, a borrower on one of these plans would be subject to the 1% calculation, and $500 would be used.

a)      1% of UPB = $500

b)      Actual payment, Standard 10-Year Repayment Plan = $575

c)       Actual payment, Extended Fixed 25-Year Repayment Plan = $347

d)      Actual payment, Graduated 10-Year Repayment Plan = $332

e)      Actual payment, Income-Based Repayment Plan = $406

f)       Actual payment, Pay as You Earn Repayment Plan = $271

In all, this change will have the effect of enabling lenders to comfortably apply lower monthly debt payments on deferred student loans than in the past. Whether fully documented or not, the outcome should be generally more favorable to borrowers. Perhaps more importantly, Fannie Mae’s new guidance should result in payment amounts that are more realistic and reasonable than the 2% Exception, resulting in a fairer and more accurate assessment of a borrower’s ability to pay.

What are your thoughts on this recent change? Please share in the comments.

Geoffrey Cooper

Geoffrey Cooper - Vice President Product Development

Geoff Cooper is Vice President – Product Development at Mortgage Guaranty Insurance Corporation (MGIC).

With over 28 years of experience in the mortgage and banking industries, Geoff has been with MGIC for 19 years in various positions, from leading the Company’s affordable lending efforts to overseeing its community bank strategy. He is also past Director of Single Family at Wisconsin Housing & Economic Development Authority, and served as Policy Advisor to the Wisconsin Commissioner of Banking.

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