Loyola University Chicago School of Law, JD 2021
In the United States, a mortgage is considered “conforming” if it meets the guidelines of Freddie Mac (the Federal Home Loan Mortgage Corporation) and Fannie Mae (the Federal National Mortgage Association). Both Freddie Mac and Fannie Mae buy mortgages, pools them, and then sells them back to the open market for investors. In 2008, the federal government put both organizations into a conservatorship due to the financial meltdown and subsequent economic recession. As such, the government now has stringent guidelines that homebuyers must meet if they want to qualify for a Freddie Mac or Fannie Mae mortgage.
Benefits of conforming loans
Conforming loans are often chosen for their benefits. Generally, the interest rates of conforming loans tend to be lower than FHA (Federal Housing Administration) loans, and significantly lower than non-prime loans (loans that are targeted towards borrowers with lower credit profiles or incomes). In addition, the down payment can be as low as 3-5% for those with excellent credit.
Debt-to-income (DTI) ratio
Both Freddie Mac and Fannie Mae, like most mortgages, have debt-to-income ratios that buyers must meet in order to qualify for a mortgage. A debt-to-income ratio measures the amount of debt that a buyer has on a monthly basis versus the income he or she brings in each month. For example, if an applicant had a monthly minimum payment of $1000 between his cars and credit cards, and he possessed a gross income of $2000 a month, his debt-to-income ratio would be 50%. This likely exceeds the amount that most conforming loans would approve, though in rare circumstances where the buyer has a large down payment and an excellent profile, Fannie and Freddie have been known to manually underwrite the loans to 50%.
Student loans and DTI ratios
Student loans can make things tricky when it comes to applying for a conforming mortgage. In the past, deferred student loans, as well as those that reflected a “zero” on the applicant’s credit report, were not counted in an applicant’s debt-to-income ratio. In 2016, the federal government changed guidelines regarding the exclusion of student loans—not just for Fannie Mae and Freddie Mac, but also for FHA loans. This required the mortgage lender to calculate a percentage of the total student loan balance against the debt-to-income ratio, making it more difficult for those with large student loan balances to qualify for a mortgage. In addition, guidelines for those on income-based repayment plans became unclear, as mortgage lenders then needed to figure out if the total loan amount would be paid off by the end of the repayment period using the amount stated on the credit report, or if the payments would be subject to increases over the years. (For example, a low monthly payment due to income-based repayment could potentially make the applicant seem as if she is more capable of taking on a larger mortgage than she would be in a few years, when that payment could potentially rise.)
In order to comply with Fannie Mae guidelines when it comes to student loans, mortgage lenders must first look at the credit report. The most recent guidelines state that should a payment amount greater than zero be reflected on the credit report, the lender can use that payment for the debt-to-income ratio. However, if the credit report does not reflect a payment or if the payment is listed as $0, the lender must determine if the amount is actually zero due to an income-based repayment plan, or in the case of deferred student loans, the 1% of the total balance as part of the debt-to-income ratio (or, alternatively, utilize “a fully amortizing payment using the documented loan repayment terms”).
In the past, Freddie Mac required 1% of the student loan balance to be counted towards the debt-to-income ratio for deferred student loans. For loans that were in repayment, regulatory guidelines required the greater amount of 0.5% of the total balance, or the payment amount listed on the credit report. In 2018, new guidelines enabled the lender to use the amount reflected on the credit report as long as the amount was greater than zero (even in the cases of income-based repayment plans), or if the amount is listed as zero on the credit report, to use just 0.5% of the total balance (as reflected on the credit report).
Impact on Student Loan Borrowers
With the increased clarity on student loan guidelines and debt-to-income ratios, and the more generous calculations of DTI and income-based repayment plans, student loan borrowers will hopefully have an easier time applying and becoming approved for a conforming mortgage.