Have Student Loans on Income-Based Repayment? Watch Your Debt-to-Income Ratio

 October 8, 2020
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Learning how to calculate debt-to-income (DTI) ratio with student loans is complicated enough. Now consider that mortgage lenders have their own formulas.

The bottom line: In the eyes of mortgage lenders, your DTI ratio changes if student loans on income-based repayment plans keep your monthly payments down.

Below, find out what the DTI ratio is, how to calculate it, why your student loan repayment plan matters for your mortgage or refinance application, and how you can make it better.

The definition of debt-to-income ratio

Your debt-to-income ratio is the amount of your income that goes towards debt payments and other financial necessities.

According to Howard Dvorkin, a certified public accountant (CPA), lenders view your overall DTI ratio as an indicator of your financial strength, just like your credit score or credit utilization.

“Lenders didn’t invent complicated formulas like debt-to-income ratios because they want to confuse you. They did it because the DTI ratio really works,” Dvorkin said. “Think about it this way: You might be making all your monthly payments with an easy smile, but you could easily be one missed payment from disaster.”

According to the Consumer Financial Protection Bureau (CFPB), mortgage studies show that borrowers with a higher debt-to-income ratio are at greater risk of not making their payments. Most lenders will only give mortgages to applicants who have a DTI ratio of 43% or lower.

How to calculate debt-to-income ratio with student loans

To learn how to calculate debt-to-income ratio with student loans, add up all of your monthly debts and expenses. Then, divide that number by your gross monthly income.

For example, let’s say you make $6,000 a month. If you pay $1,000 a month on housing, $500 on student loans and $500 on credit card debt, your total debts are $2,000.

If you divide your total debt by your gross income ($2,000 divided by $6,000), your DTI ratio is 33%.

Use the calculator below to find your DTI ratio.

Debt-to-Income (DTI) Calculator

When mortgage lenders look at your debt-to-income ratio

Your debt-to-income ratio can impact you in many ways, but it’s particularly important if you are interested in buying a home. Lenders look at your DTI ratio to make sure you have enough income to keep up with your mortgage payments while staying current with your other financial responsibilities, such as student loan repayment.

Depending on what type of mortgage you are applying for, lenders may have more stringent requirements than the 43% ratio mentioned above.

Your debt-to-income ratio is one of the biggest factors lenders consider. In fact, a 2017 study by the Federal Reserve showed that 23% of mortgage loan rejections were due to DTI ratios that were too high.

If you are already a homeowner, your debt-to-income ratio can affect whether or not you can refinance your mortgage to take advantage of lower interest rates.

Debt-to-income ratio with student loans on income-based repayment

Many student loan borrowers think that they can improve their chances of getting a mortgage or refinancing by signing up for an income-driven repayment (IDR) plan (commonly referred to as income-based repayment, one of four IDR plans). Through an IDR plan, you can get a lower payment, freeing up more money each month.

However, lenders don’t look at your student loans that way under an income-driven repayment plan. They calculate your DTI ratio very differently, and learning how to calculate your debt-to-income ratio like a lender can save you a lot of time and frustration.

Consider the calculations used by the lenders of federally backed convention home loans, for example:

  • Fannie Mae will use the monthly payment as listed on a borrower’s credit report or student loan documentation, even approving borrowers with monthly IDR payments of $0.
  • Freddie Mac will also first consider the borrower’s monthly dues, but if their IDR payment is $0, the lender will use 0.5% of the outstanding balance. Also, it will leave student loan payments out of the equation if the borrower is 10 or fewer payments away from receiving student loan forgiveness.

Of course, the math varies among other, non-conventional federal loan programs:

Figuring debt-to-income ratio with student loans on income-based repayment and other IDR plans
Loan type Rule of thumb
Federal Housing Administration (FHA) Your payment amount, or 1% of your student loan balance (whichever is greater)
Department of Veterans Affairs (VA) Your payment amount, or 5% of the annual balance (depending on the lender)
U.S. Department of Agriculture (USDA) Your payment amount, or 0.5% of your student loan balance (whichever is greater)

While the 1% rule is still common, it was once the standard. Lenders like Fannie Mae targeted your monthly payment as 1% of your total loan balance, or would use a monthly payment that will completely pay off your loan without any of the balance being forgiven.

For example, let’s say you have $30,000 in student loans, and under an IDR plan your monthly payment is just $50. Because that $50 payment would not be enough to pay off the loan in full, the lender would calculate your payment with a new amount. They could set your payment for their calculation purposes as 1% of your loan, or $300 a month.

To determine whether you’re IDR payment would be enough to pay off your loan in full on schedule — and avoid a mortgage lender’s potential 1% imposition — consult our calculators for your repayment plan:

What if you’re trying to buy a home while receiving coronavirus student loan relief?
● The math can be thrown off if you’re currently receiving the widely offered 0% interest administrative forbearance awarded on federal student loans.
● In the eyes of mortgage lenders, your monthly loan payment being $0 makes you a riskier customer. They may assume your monthly payment is simply 1% of your outstanding balance, affecting your loan amount eligibility.
● You may find yourself having to explain these particulars to your prospective mortgage lender, asking them to make an exception in this unusual case.

How these DTI ratio calculations can hurt you

With many students coming out of school with significant debt and comparatively low salaries, using the 1% guideline rather than using the payment under an IDR plan makes homeownership impossible for many.

Even those without additional debt and with good credit may struggle to get approved for a mortgage or refinancing loan if their debt-to-income ratio is too high.

“If you’re carrying hefty credit card balances and even weightier student loan debt, and those payments consume half of everything you earn every month, you have no margin of error,” Dvorkin said. “Lenders are nervous about adding a mortgage on top of that shaky situation.”

Plus, if you’re planning on borrowing a non-conventional federal home loan, you could receive less favorable terms as a result of how your debt-to-income ratio is figured. It’s important to understand how your DTI ratio is calculated differently by lenders of FHA, VA and USDA home loans (see above).

What to do if your DTI ratio is too high for mortgage lenders

Learning how to calculate debt-to-income ratio is an important first step — but what if your DTI ratio is too high to get approved for a mortgage?

You have a few options:

  • Rather than heading straight to the big lenders, you can meet with a mortgage broker to find out if there is a smaller bank or credit union that would be willing to give you a mortgage. Many smaller financial institutions have less rigorous guidelines.
  • Shop for a less expensive home — your mortgage payment would be smaller, and you would need less income to make your payments.
  • If you have your heart set on a certain type of home but you just cannot get approved right now, you can work hard on side gigs to pay extra money towards your student loans. By paying off as much as possible, you can reduce your debt-to-income ratio and become more attractive to lenders.

Andrew Pentis contributed to this report.