If you’re applying for a mortgage or refinancing your home, you likely have come across the term “debt-to-income ratio” (DTI). This ratio is a pivotal calculation that determines whether or not a lender will approve you for a loan.
But if you have student loan debt and are on an income-driven repayment plan, the DTI ratio can be more complicated, depending on how the lender views your payments.
Below, find out how to calculate debt-to-income ratio and how your student loan repayment plan can affect your mortgage or refinance application.
What is a 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, lenders view your overall debt-to-income 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 DTI really works. 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,” says Dvorkin.
According to the Consumer Financial Protection Bureau, studies of mortgage loans 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 of 43 percent or lower.
How to calculate debt-to-income ratio
To figure out your debt-to-income ratio, 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, your DTI is 33 percent.
Use the calculator below to find your DTI.
When lenders looks 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.
Depending on what type of mortgage you are applying for, lenders may have more stringent requirements than the 43 percent ratio mentioned above.
Your DTI is one of the biggest factors lenders consider. In fact, a recent study by the Federal Reserve showed that nearly 25 percent of mortgage loan rejections were due to debt-to-income ratios that were too high.
If you are already a homeowner, your DTI can affect whether or not you can refinance your mortgage to take advantage of lower interest rates. Most lenders will only allow you to refinance if your ratio is 28 percent or less.
How income-driven repayment plans can affect your DTI ratio
Many borrowers think that they can improve their chances of getting a mortgage or refinancing by signing up for an income-driven repayment (IDR) plan. 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.
Lenders like Freddie Mac and Fannie Mae have changed their guidelines to evaluate borrowers on income-driven repayment plans. Instead of using the IDR monthly payment, lenders set your monthly payment as one percent of your total loan balance, or will 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 one percent of your loan, or $300 a month.
How these DTI calculations can hurt you
With many students coming out of school with significant debt and comparatively low salaries, using the one percent guideline rather than using the payment under an IDR plan makes home ownership 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. Lenders are nervous about adding a mortgage on top of that shaky situation,” says Dvorkin.
What to do if your DTI ratio is too high
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.
Alternatively, you can shop for a less expensive home — your mortgage payment would be smaller and you would need less income to make your payments.
Finally, if your 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 loans. By paying off as much as possible, you can reduce your debt-to-income ratio and become more attractive to lenders.
For more information on how to pay down your loans quickly, learn about two effective approaches to paying off debt.