So you’re ready to buy your dream home — open floor plan, hardwood floors, big, beautiful windows — you’ve got it all planned. You’ve been scrimping and saving, and you think you might just be able to afford it with a loan from the bank. But…what if you weren’t eligible to take out that loan?
While lenders typically consider your FICO or other credit score to determine the interest rate on your loan, there’s another factor that lenders consider, which determines whether you can get a loan at all — your debt-to-income ratio, or DTI.
Why is DTI so important? DTI is simply the ratio of your debt to your income; so the more debt you have to pay off, the less income you have leftover to use toward new debt (in this case, a mortgage).
Your various debts can pile up quickly and cause your DTI to skyrocket. Say, for example, that you already have credit card debt and rent, and are making car payments too when you decide to buy your home. As the interactive graphic above shows, at this point, your DTI is still relatively low. But if you’re one of the millions of Americans burdened with student loan debt, your DTI very quickly reaches problematic levels, especially if you have a degree in fields like psychology, education, or history.
How much debt is problematic?
A good rule of thumb is to try and keep your DTI at 36 percent or lower. According to the National Foundation for Credit Counseling (NFCC), a DTI of higher than 36 can put you in a dangerous position.
Now, student debt or credit card debt alone might not mean that you can’t afford the mortgage on your forever home. But chances are that you have more than just one type of debt, which could make it harder to responsibly take on more debt, particularly a mortgage.
The lowest mortgage rates are offered by lenders who plan to package up loans that can be guaranteed by Fannie Mae or Freddie Mac and sold to investors. But even Fannie Mae prefers borrowers with a DTI of 36 percent or less — that’s including your car payments, student loans, and credit card debt, along with the mortgage payment.
While Fannie Mae will sign off on borrowers with DTIs up to 45 percent, they must have good credit scores and make substantial down payments. FHA-backed mortgages — a favorite among younger homebuyers who don’t have much money saved up for a down payment, and who are willing to pay additional mortgage insurance premiums — are in most cases off limits for borrowers with DTIs exceeding 43 percent.
The Consumer Financial Protection Bureau also highlights 43 percent as a number to keep an eye on, because it is generally the highest DTI you can have and still be eligible for a Qualified Mortgage. Remember — just because you think you can afford the mortgage payment doesn’t mean you can afford the house.
If you are paying off a lot of student loan debt, one way you can reduce its impact on your DTI is to refinance your student loans at a lower interest rate. If you have a good credit rating and employment history, private lenders are often able to offer lower rates than on some government loans -- particularly loans taken out to attend graduate school. You can see how much you might save by refinancing by comparing offers from multiple, vetted lenders at Credible.com.
Refinancing with a private lender isn’t for everyone. If you’re struggling to make your monthly loan payments on your government student loans, you might want to consider enrolling in an income-driven repayment plan.
Income-driven repayment plans like REPAYE limit your monthly loan payment to 10 percent of your disposable income by stretching your loan term out to as long as 25 years. The trade off for being able to make smaller monthly payments is that you may end up paying considerably more interest in the long run. Credible’s REPAYE guide can help you decide whether a repayment plan is right for you.
Ariha Setalvad is a member of the DailyWorth Connect program. Read more about the program here.