Your credit score is an important factor with just about any type of loan. But with student loan refinancing, your debt-to-income (DTI) ratio could be more of a problem.
In a recent Student Loan Planner survey, 48 percent of refinancing applicants said they got rejected, because of a high DTI ratio. In contrast, only 14 percent said they got rejected because of their credit score.
If you’re thinking about refinancing your student loans, find out what is a good debt-to-income ratio, how it works and what you can do to decrease it.
What is a debt-to-income ratio?
A debt-to-income (DTI) ratio is a simple calculation lenders use to assess your ability to manage new debt on top of the payments you’re already making.
In most cases, lenders get your DTI ratio by dividing your total monthly debt payments by your gross monthly income, which is what you make before tax and other deductions. an example, let’s say you earn $75,000 per year and you have the following monthly payments:
- Student loans: $350
- Car loan: $300
- Mortgage: $1,200
- Credit cards: $200
Your total monthly payments of $2,050 divided by your gross monthly income of $6,250 give you a DTI ratio of 32.8%.
The lower your DTI ratio, the more likely you’re able to make all your payments on time. If you have a high DTI ratio, however, it could be a sign that you may have trouble paying your debt in the future. If this is the case, a new lender may offer a higher interest rate to compensate for the extra risk or deny your application altogether.
How do student loans affect debt-to-income ratio?
With most types of loans, a lender considers all of your debt payments when calculating your DTI ratio, including your student loans. If you’re applying for a mortgage, you may see two calculations: front-end DTI and back-end DTI. But student loans only affect the back-end DTI.
What is a good debt-to-income ratio?
Each lender has its own criteria for creditworthiness, so it’s impossible to know exactly what is a good student loan debt-to-income ratio to qualify for student loan refinancing. Lenders also typically don’t publicly share a maximum DTI ratio, making it difficult to know whether you should apply.
In general, though, the Federal Reserve considers that a DTI ratio of 40% or more is a sign that you’re financially stressed. If your ratio is close to that, it’s worth trying to bring it down before applying for student loan refinancing.
How to lower your debt-to-income ratio
Because your DTI ratio only uses two variables, knowing how to lower your DTI ratio for student loan refinancing is pretty simple: either reduce your debt or boost your income.
Decreasing your debt
If your student loans make up the majority of your debt burden, it can be tough to pay them down more quickly without refinancing them. The same goes if you have other debts that push your DTI ratio past the 40% threshold. Here are some tips:
- Cut back on discretionary spending: Focus on budgeting on discretionary categories, such as eating out and entertainment instead of essentials like groceries and utilities.
- Snowball your debts: If you have multiple types of debt, target the account with the lowest balance first. Once it’s paid off, apply that payment to your debt with the next lowest balance, and so on.
- Try the debt avalanche: This strategy works much like the debt snowball method. But instead of targeting your debts by lowest balance, focus on accounts with the highest interest rates first.
- Stop adding more debt: If you have credit cards, consider putting them in a sock drawer while you’re paying off debt. Also, avoid taking out new loans if you can.
Whatever your situation, set a goal for how much debt you want to pay off and create a plan to make it happen.
Increasing your income
If you’re having a hard time finding ways to pay down your debt faster let alone get by, boosting your income may be a more practical solution.
Start by looking for opportunities to increase your income at your job. For example, if you haven’t received a raise in a while but deserve one, or you can work more overtime. Or you know you can earn more doing a different job you’re qualified for, but haven’t pursued it because change is hard.
Think about how to approach your manager for a raise or beef up your resume to get a better job.
Another way to increase your income is finding ways to earn money on the side. For example, you can take a job driving for Lyft, or delivering for Postmates on the weekends. If you have a specialized skill, such as writing or graphic design, you may find clients who are willing to pay for your services.
You may cycle through a few before you find one you enjoy — that’s OK. That extra income can make a big difference in your chances of refinancing your student loans.
Lowering your DTI ratio takes time, so it’s good to start sooner than later. Before you start that process, calculate your ratio to see whether you even need to focus on it. What is a good debt-to-income ratio? If your ratio is below 40%, you may have a good chance of getting approved for student loan refinancing.
If not, work on a plan to reduce your debt, increase your income, or both. The process takes a while, but if it can help you refinance your student loans and get a lower interest rate, it’s well worth the effort.
Are there any debts you are hoping to pay off this year?