How Do Student Loans Impact Debt to Income Ratio?

Lenders consider many factors, like your credit score, when deciding on whether to lend you money. However, another factor that’s just as important is your debt-to-income ratio or DTI. 

If you’re a student loan borrower, your monthly payment and loan amount might hurt your DTI, making you a less attractive applicant to lenders. Keep reading to learn how your debt-to-income ratio and student loans can affect your finances. 

Understanding debt-to-income ratio

Debt-to-income ratio (DTI) shows your debt obligations in relation to your income and is used as a measure of financial stability by lenders. In other words, lenders want to know that you can reasonably afford your current and future debt payments with your current income. 

If your DTI is too high, you might be considered a high-risk borrower. A lower DTI illustrates that your finances have some breathing room.

Your DTI is calculated by adding up all of your monthly debt obligations, divided by your total gross monthly income. 

DTI = Total monthly debt obligations/Total gross monthly income 

So let’s say you add up your auto loan, mortgage payment, credit card debt payment, and student loans. 

Auto loan: $300
Mortgage payment: $1600
Credit card debt: $250
Student loans: $450 

Total monthly debt obligations: $2,600 

In this example, imagine your gross monthly income — which refers to income before taxes or deductions are taken out — is $6,000 per month. 

Given the DTI formula above, your calculation will look like this:

$2,600/$6,000 = 0.433

Typically, DTI is expressed as a percentage, so multiply the result by 100. 

0.433 X 100 = 43% DTI

In other words, 43% of your income goes toward monthly debt obligations. A 43% DTI is generally the maximum limit that’s considered “good” to potentially qualify for a mortgage. Generally, a 36% DTI or lower is ideal and attractive to lenders. It shows that you have room to make your monthly payments and still have income left over. 

The impact of student loans on your DTI

When it comes to debt-to-income ratio and student loans, your monthly payment is used as part of the calculation. Whether it helps or hurts your DTI will depend on the size of your monthly student loan payment. 

The example above, including a $450 monthly student loan payment leads to a DTI of 43%. This is about as high as you want to go. Aiming for a lower percentage is a good idea if you’re looking to apply for a loan or new credit. 

Let’s imagine you’ve paid off your student loans, and that’s wiped out from the equation. 

That would lower your debt obligations to $2,150. 

$2,150/$6,000 = 0.358 (round up) 

.36 X 100 = 36%. 

Without your student loans, you’re suddenly in the ideal range of 36% DTI or less. 

If you have a lower payment, it can improve your DTI. This may be done through an income-driven repayment plan (IDR) or student loan refinancing (more on that later). 

But what if your monthly payment has been on pause, such as deferment or forbearance? Will that magically improve your DTI? Not quite. 

According to Fannie Mae, student loans in deferment and forbearance aren’t excluded from qualifying for a mortgage. 

If your credit report shows that your payment is $0, Fannie Mae may calculate a payment equal to 1% of your outstanding loan balance. However, if you do make a payment and it shows on your credit report, that amount may be used. A 1% calculation may lead to a higher DTI compared to your actual payment. 

The Federal Housing Administration guidelines reduced its calculation to 0.5% of the student loan balance if the payment is reflected as $0 on an applicant’s credit report. Depending on how much you owe, it can be advantageous to make payments to lower your DTI, instead of 0.5% to 1% of the balance. 

For example, let’s say you owe $50,000 in student loans, and your payment is $0 currently. Using the 1% rule for Fannie Mae, your payment may be calculated at $500. 

If you’re on any of the income-driven repayment plans, your payment may actually be lower than this amount. So in some cases, making student loan payments could be better if you want to be a good candidate for mortgage lenders. 

How lenders view debt-to-income ratio

There isn’t just one factor that lenders look at when you apply for credit or a loan. Your credit score shows the likelihood of paying back your debt. Your debt-to-income ratio is more about affordability and financial wellness. 

If your debt-to-income ratio is too high, it may make you ineligible for a mortgage or other types of loans. 

Fannie Mae states that the maximum DTI eligible for a loan is 50%, if certain conditions are met. Ideally, the DTI would be lower than 36%, and if it exceeds 50%, you may not qualify. 

Over 50% DTI might signal to lenders that you’re maxed out, and too much of your income is going toward debt. 

Also, lenders may actually look at two versions of the debt-to-income ratio. Most lenders refer to the “back-end” ratio, which includes housing and all of your debt obligations. “Front-end” ratio refers to only housing costs relative to your income. 

According to the FDIC, mortgage lenders typically want your front-end ratio to be between 25% and 28%. In other words, your total housing costs won’t exceed 25% to 28% of your gross income. The preferred back-end ratio is between 33% and 36%. 

Your debt-to-income-ratio and student loan repayment

Now that you have some DTI benchmarks, you might wonder what your debt-to-income ratio and student loans mean for you as a borrower. 

You might be able to lower your DTI ratio through student loan refinancing or going on an income-driven repayment plan and going for forgiveness. 

Refinancing can help you change your repayment term, which may lower payments. Just know it’ll cost you more in interest. Similarly, an IDR plan extends your repayment term and lowers monthly payments. 

But these strategies are very different and are for two different types of borrowers. Here’s a benchmark to consider.

If you take your total student loan debt and divide it by your income and get less than 1, consider refinancing. If it’s above 2, consider student loan forgiveness. 

Let’s say you owe $50,000 in student loans, and you make $100,000. That equals 0.5, which is less than 1, so refinancing to a lower rate may be helpful. 

If you owe $200,000 and make $75,000, that equals 2.6. Since it’s above 2, opting for student loan forgiveness would be best. 

You’ll need to meet the student loan refinancing company's eligibility requirements or qualify for forgiveness. 

Many refinancing companies have a maximum DTI of 40% to 50% to qualify. Forgiveness may come with work-based requirements under the Public Service Loan Forgiveness program (PSLF), though you may opt for IDR forgiveness which doesn’t have the same constraints. 

How to improve your DTI

If you’re worried about your debt-to-income ratio and student loans, there are things you can do to help. You basically have two options — boost your income or reduce your debt load. This may mean:

• Taking on a side hustle.
• Asking for a raise.
• Paying off smaller credit card balances.
• Avoid taking on new recurring debt.
• Lowering monthly student loan payments through IDR or refinancing. 
• Making extra payments. 

Lowering your DTI before applying for credit or a loan can be a smart idea, especially if it’s a mortgage. That way, you increase your approval odds and aren’t considered as risky. It also ensures that you have extra room in your budget to tackle an extra payment and won’t be financially strapped. 

If you want support with your student loan repayment strategies, book a consult with Student Loan Planner.