You recently applied for student loan refinancing, a car loan, or maybe a mortgage, but soon after are notified that your application was not accepted. Denied. Your credit score is solid, you make a decent living, and you’ve never missed a payment. What gives?
There’s one factor you might not be considering: your debt-to-income ratio.
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 DTI for short, it’s an important number in your financial life.
When applying for a loan or other type of credit, many lenders look at not only your overall credit score, but also 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 lending you any more money.
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 appear as a risk to creditors and make it difficult to reach your financial goals.
Front-end vs. back-end DTI
As if the whole concept of DTI weren’t complicated enough, you actually have two different debt-to-income 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 percent or less. For back-end DTI, the standard benchmark is typically 36 percent or less. These numbers aren’t set in stone and may vary by lender, but 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, 43 percent is the maximum DTI a borrower can have in order to get approved for a qualified mortgage.
How student loans impact your debt-to-income ratio
Your student loans aren’t accounted for in the front-end debt-to-income 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 with student loans, refinance your student loans, 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 debts 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 = a DTI of 51.6 percent. Yikes!
Debt-to-Income (DTI) Calculator
If over half of your income would be going to your debt obligations, you won’t get approved for that mortgage.
“I think 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, borrower experience lead 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.
How to improve your debt-to-income ratio
If you’re thinking of applying for a credit card, mortgage, car loan, student loan refinancing, etc., it’s important to not only maintain good credit, but a healthy debt-to-income 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 debt-to-income ratio. If it’s too high, you may want to hold off for a while until you improve your situation or risk rejection.
I’ll let you in on a little secret: I was actually rejected for student loan refinancing because of my debt-to-income ratio. 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. If your loans are the same or even higher than your salary, it’s likely your DTI is 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:
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.
$1,050 divided by $3,000 = 35 percent
By focusing on eliminating debt, your DTI would drop from over 50 percent to 35 percent. 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!” or “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.
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