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The debt-to-income ratio is a tool lenders use to determine whether or not you can afford to pay back your loan, and it’s important that you understand how it works in order to make the best decision possible about your financing.
The debt-to-income ratio (DTI) is calculated by dividing your monthly debt payments by your gross monthly income. This number represents the percentage of the time that you have available to pay off your debts each month.
If you have a DTI of less than 36%, then you’re likely able to afford your loan payments, as well as all other bills and expenses. However, if your DTI exceeds 36%—or if your total monthly debt payments are more than 50% of what you earn—then you may have trouble paying off all of those bills on time.
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What about front-end vs. back-end DTI?
As if the whole concept of debt-to-income ratio weren’t complicated enough, you actually have two different DTI ratios: front-end DTI and back-end DTI.
Your front-end debt-to-income ratio is how much of your gross income goes toward housing costs, such as mortgage payments and insurance. If you don’t yet own a home and are applying for a mortgage, your front-end DTI is what you would be paying if you were approved.
Your back-end debt-to-income ratio is how much of your gross income goes toward all of your debt obligations, including credit card payments, student loan payments, mortgage — even child support and alimony.
Typically, lenders would like your front-end DTI to be 28% or less. For back-end DTI, the standard benchmark is typically 35% or less. These numbers aren’t set in stone and may vary by lender, but if you have a generally high debt-to-income ratio, you may have difficulty getting approved for new loans.
In fact, according to the Consumer Financial Protection Bureau (CFPB), 43% is the maximum DTI a borrower can have in order to get approved for a qualified mortgage.
How do student loans impact your debt-to-income ratio?
Your student loans aren’t accounted for in the front-end DTI ratio, but that debt certainly impacts the back end. If you have a steep student loan balance, your DTI can be high — in some cases, too high, effectively limiting your options to buy a house while owing student loans, to refinance your student debt, and more.
For example, let’s say you are applying for a mortgage. Your gross income (before taxes) is $3,000 per month and your monthly debt breakdown looks like this:
Estimated mortgage payment and insurance = $1,000
Student loan payment = $300
Credit card payment = $50
Car payment = $200
In this scenario, your total debt payments add up to $1,550 per month. To find out your DTI, you’d divide your total debts by your gross income, or use the calculator below.
With either method, you’ll find that your monthly debt of $1,550, divided by an income of $3,000, comes out to a rather high DTI of 51.6%.
How Student Loans Impact Your Debt-to-Income Ratio
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Your credit score might seem like the be-all and end-all when applying for student loan refinancing, a car loan or a mortgage. But even with a solid credit history and cash flow, you could be denied funding.
What is a debt-to-income ratio?
Your debt-to-income ratio is a percentage of how much debt you owe relative to your income. Often referred to as a “DTI” ratio for short, it’s an important number in your financial life.
When applying for a loan or other type of credit, many lenders look not only at your overall credit score, but also at your DTI to determine if you’re a good candidate. If a large chunk of your income is going to debt each month, lenders may be wary of extending further credit.
The lower your debt-to-income ratio, the better. But if you have pesky student loans, they could be pushing your DTI into the red zone, which can make you look risky to creditors and make it difficult to reach your financial goals.
Based on an income of $60,000, monthly housing costs of $900 and $100 in other monthly debt payments, your Front-End DTI is 18% and your Back-End DTI is 20%.
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How do debt-to-income ratio and student loans affect your mortgage?
If over half of your income would be going to your debt obligations — as in the example above — you won’t get approved for that mortgage.
“Debt-to-income ratios are about to become very problematic for people who carry student loan debt and want to buy a house,” said Aaron LaRue, a former product manager at Clara Lending, which is now part of SoFi.
“When applying for a home loan, debt-to-income ratios can be one of the largest limiting factors when calculating home affordability. I’d argue that this is a bigger issue than having a low credit score. As far as qualifying, it’s right up there with how much you have for a down payment,” LaRue added.
And if you don’t have much for a down payment, your DTI could matter even more. A down payment is a way for lenders to reduce risk — the more you pay upfront, the less they need from a mortgage. A 20% down payment is the standard amount if you want to avoid paying private mortgage insurance (PMI), although the Federal Housing Administration (FHA) loan program offers mortgages down payments as low as 3.5%.
But for younger generations, student loans may make home ownership a tough goal to achieve. Nearly 1 in 4 recent graduates say their education debt has stopped them from moving, let alone buying a home, according to our 2019 milestones survey.
How can you improve your debt-to-income ratio, student loans and all?
If you’re thinking of applying for a credit card, mortgage, car loan, student loan refinancing or another type of funding, it’s important to not only maintain good credit, but a healthy DTI ratio as well.
For example, when mortgage lenders examine your back-end DTI, a large student loan payment can be “a killer,” according to LaRue. “A monthly payment of a few hundred dollars can translate to a loss of tens of thousands of dollars off of your maximum home purchase price,” he explained.
Before you go after a big financial goal, calculate your DTI ratio. If it’s too high, you may want to hold off for a while until you improve your situation. Otherwise, you’re much more likely to face rejection.
How your DTI impacts your student loan refinancing application
I’ll let you in on a little secret: I was actually rejected for student loan refinancing, and honestly, I should’ve known better, considering I was making $30,000 at the time and my student loans balance was also at $30,000.Unfortunately, my situation then is still common these days. About 46% of student loan borrowers who left school in the last five years say that their outstanding balance trumps their salary, according to the 2019 survey cited above.If your loans are the same level or even higher than your salary, it’s likely your DTI is also too high!
But before you give up on applying for a mortgage or refinancing forever, there are ways you can improve your debt-to-income ratio:
Ask for a raise
Earn more through side hustling
Pay off your debt ASAP
In other words, to improve your DTI, you need to earn more, get rid of some debt, or both.
Given the example above, if you were to focus on eliminating your student loans and car loan, you’d be left with a prospective $1,000 mortgage payment and $50 credit card bill each month. And $1,050, divided by $3,000, comes out to a more reasonable 35%.
If you want to improve your debt-to-income ratio to pursue your big life goals, make it a point to pay off your debt as soon as possible and find ways to supplement your income. It could mean the difference between getting a letter that says, “Congratulations!” and one that begins, “We regret to inform you…”
By preparing now and understanding how student loans affect debt-to-income ratio, you can take the necessary steps to go after what you want without being automatically rejected.
Andrew Pentis and Dillon Thompson contributed to this report.
Student loans can be a major source of debt, but they’re not the only source.
In order to keep your student loans from affecting your debt-to-income ratio, you’ll want to pay off your student loan debt as quickly as possible while also making sure that your other debts are under control. If you have any questions about how best to manage these obligations, don’t hesitate to reach out—we’re here for you!