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When you apply for credit, your debt-to-income ratio (DTI) is an important factor that lenders consider, especially if you're applying for a mortgage loan. Along with other debt payments, your monthly student loan payments are included in that debt-to-income ratio calculation.
Here's what to know about how the debt-to-income ratio works, why it's important, how student loans are incorporated and what you can do to lower your debt-to-income ratio.
What Is a Debt-to-Income Ratio?
Called DTI for short, your debt-to-income ratio is the percentage of your gross monthly income that goes toward debt payments.
To calculate it, simply add up all of your debt payments—don't include things like utilities and subscriptions—and divide the sum by your gross monthly income, which is what you earn before taxes, not your take-home pay.
Lenders use your debt-to-income ratio to determine whether you're financially able to take on more debt. It's especially important if you're applying for a mortgage and directly impacts how much house you can afford.
While most lenders include all of your debt payments together, mortgage lenders break down the ratio into a front-end DTI, which includes only your monthly housing costs, and a back-end DTI, which includes all of your debt payments.
Mortgage lenders typically like to see a front-end DTI of 28% or lower and a back-end DTI of 36% or lower, but it can go as high as 43% with many lenders and even 50% in some instances. Most other loan types require a DTI of 50% or lower.
How Do Student Loans Affect Your Debt-to-Income Ratio?
As with any other debt obligation, the monthly payments on your student loans are factored into your debt-to-income ratio. In some cases, mortgage lenders may treat student loans differently than other types of debt, but they're almost always in the formula.
To give you an idea of how student loans can impact your DTI, let's say you earn $5,000 in gross monthly income and have the following debt payments:
- Mortgage loan: $1,400
- Student loans: $300
- Auto loan: $400
- Credit cards: $120
In total, your DTI is about 44%, which puts you just over the line to obtain a qualified mortgage, meaning that the loan meets the federal requirements to ensure that you can repay it.
Without the student loan payment, however, your DTI would be roughly 38%, below the 43% threshold for qualified mortgage loans.
Are Student Loans in Deferment or Forbearance Included in Debt-to-Income Ratio?
Deferment and forbearance plans allow you to pause your student loan payments for a period of time set by your lender. But while you're not financially obligated to make those payments, you're not off the hook with your debt-to-income ratio.
Depending on which loan program you're applying for, the figure the lender uses can vary when adding your student loans into your DTI. With conventional loans, for instance, Fannie Mae requires lenders to use the regular monthly payment or an amount equal to 1% of the outstanding loan balance.
Freddie Mac, on the other hand, requires conventional lenders to use an amount equal to 0.5% of the loan balance if there's no current monthly payment required. That said, the government-sponsored enterprise says lenders can exclude your student loan payment if:
- You have 10 months or less worth of payments, or
- You're in deferment or forbearance and qualify for forgiveness at the end of the deferment or forbearance period.
If the loans have already been forgiven or paid off, there's no monthly payment to include.
Other loan programs may have differing requirements. So, if you're thinking about applying for a mortgage, be sure to ask your loan officer or mortgage broker about your specific situation and the loan program to see how a lender will handle your student loan payments.
How to Reduce Your Debt-to-Income Ratio
Cutting your debt-to-income ratio can create more financial opportunities for you and also relieve some of the stress on your budget. As you grapple with student loan debt, here are some potential ways you can reduce your DTI:
- Pay off smaller balances. If you have multiple loans and some have relatively small balances, paying them off quickly can immediately remove those loan payments from your DTI.
- Switch to an income-driven repayment plan. If you have federal student loans, you can choose from up to four repayment plans that may reduce your monthly payment down to 10% to 20% of your discretionary income, which can lower your DTI.
- Refinance your student loans. If you have private student loans, refinancing them with another private lender could potentially help you secure a lower interest rate and lower monthly payments. You can also reduce your payments by requesting a longer repayment term than what you're currently on, though that will increase your total interest costs. Refinancing federal student loans may not be advisable if you anticipate needing access to forgiveness programs, income-driven repayment plans and generous forbearance and deferment programs.
- Apply with a co-borrower. Applying with a co-borrower means that the lender will consider both applicants' DTIs. If yours is high, applying with someone who has a low DTI could help you get approved.
- Increase your income. While this may be easier said than done, look for opportunities to increase your main income by applying for a better-paying job, asking for a raise or taking on overtime hours. While a side hustle can help you with your budget, it may not help with a loan unless you've been earning money on the side for at least two years.
Take time to consider all of your options and pursue the ones that work best for you and your situation.
Don't Forget to Prioritize Your Credit Score
While your debt-to-income ratio is an important factor in determining whether or not a lender will approve your application for credit, your credit score is crucial. If you manage your debt well, you may already have good credit. But it's a good idea to monitor your credit regularly to keep track of your progress and avoid any surprises that can do some damage in the long run.