It is estimated that seven out of ten college graduates will leave school with an outstanding debt of around $28,950. If you want to be approved for a mortgage but still have student loans, you have to know how these loans will affect your ability to buy a home. When it comes to getting a mortgage, you have to figure out one important thing: your debt-to-income ratio (DTI). This ratio is what mortgage lenders use to see how much of a mortgage you’ll qualify for, if anything at all.
How Mortgage Approval Works
Mortgage lenders use the debt-to-income ratio as a way to measure your ability to meet the monthly home payments. Thankfully, calculating this ratio isn’t nearly as complicated as it seems.
There are two types of debt-to-income ratios that mortgage lenders compute when you apply for a mortgage:
- The front-end ratio, also known as the housing ratio, shows what percentage of your income would go to your projected housing expenses. This includes the estimated mortgage payments, insurance payments, property taxes and association dues (if there are any). To compute the front-end ratio, simply add up all of your expected housing expenses and divide it by your gross monthly income.
- The second type of debt-to-income ratio is called the back-end ratio, which is the more important of the two types. The back-end ratio shows what portion of your income goes to ALL of your monthly debt payments. This includes your credit card bills, car loans, student loans, in addition to your expected mortgage payments and other housing expenses. You then divide this number by your gross monthly income. The result is your back-end debt-to-income ratio.
You should note that the lenders don’t look at your annual income or your total debt. What is important for lenders is to see what your month-to-month debt obligations are, and if you can still afford a mortgage payment. After all, it’s important that you be able to afford the additional monthly expense you would be taking on.
How Student Loans Affect Your Debt-to-Income Ratio
In order to see how student loans affect the debt-to-income ratio, let’s use the example of Jim, who has a monthly salary of $4,000 and wants to apply for a mortgage. Jim has student loans that amount to $28,950. Assuming he has standard Stafford loans at a 4.6% interest rates, his monthly payment is around $310. Jim doesn’t have any credit card payments or car payments, but his projected mortgage payment will be $690, so his total debt expenses every month will be roughly $1,000. By dividing his monthly debt payments ($1,000) by his gross monthly income ($4,000), the mortgage lender finds that Jim has a 25 percent debt-to-income ratio. Mortgage lenders will typically not approve if this ratio exceeds 43 percent. If Jim had other loans, this would increase his monthly debt payments. If he had monthly debt payments and projected mortgage payments that amounted to $2,000, then this would have a debt-to-income ratio of 50%, and would most likely not be approved for the mortgage.
How to Improve Your Debt-to-Income Ratio
Aside from the obvious things that you can do, such as picking up a second job, taking on freelance work or reducing your monthly expenses, here are two other ways you can improve your debt-to-income ratio:
- Look for a credit card that has an annual percentage rate (APR) lower than your student loan interest rate. You can use this credit card to pay off some of your existing student loans. In doing so, you lessen your monthly debt payment, which in turn will affect your debt-to-income ratio. You may also use this credit card to pay off other debts that have higher interest rates like car loans.
- Switch your student loan repayment plan. You can change your repayment plan from Standard Repayment to Graduated Repayment, which will result in a lower monthly payment. A Graduated Repayment starts out low and increases every two years. This kind of student loan is great if you’ve just graduated or are starting a career, since the likelihood is you’ll be making more money in 2 years than you are today.