When you apply for a mortgage, lenders consider your debt-to-income (DTI) ratio to determine if and how much you can borrow. If you're making student loan payments, those payments affect your DTI.
When it comes to paying back your student loan debt, you have a choice of different repayment plans. Some of your options include income-driven repayment (IDR) plans that base the amount of your payments on a percentage of your income. Here’s what you need to know about your IDR plan and the way it impacts your DTI and mortgage eligibility.
Debt-to-Income (DTI) Ratio and Mortgage Eligibility
Your debt-to-income (DTI) ratio is a measure of your total monthly debt payments relative to your monthly income. Lenders use DTI to assess the likelihood you'll be able to make your mortgage payments. They often see borrowers with a higher DTI as more likely to struggle to pay their loans.
There are actually two DTIs that mortgage lenders often consider:
- Your front-end ratio: This divides your total housing expenses by your gross monthly income. For example, if your mortgage payment, home insurance, and property taxes add up to $1,000 and your gross monthly income is $4,000, your front-end ratio would be 25% ($1,000 / $4,000).
- Your back-end ratio: This divides all your monthly debt payments (housing included) by your gross monthly income. If your total monthly debts including your future mortgage payments, student loans, car payments, and other obligations are $2,000 and your gross monthly income is $4,000, your back-end ratio would be 50% ($2,000 / $4,000).
Mortgage lenders often have a maximum DTI ratio in mind for their borrowers. It varies by lender and loan type. In some cases, the back-end ratio could be as high as 50%. Generally, however, mortgage lenders prefer a front-end ratio below 33% and a back-end ratio below 38%. It’s also important to consider what your net monthly income is—the amount you actually take home. These DTIs are based on gross income—the money you make before taxes and other deductions—and may not accurately reflect what you can afford per month.
Your DTI ratio is one of the most important factors in determining mortgage loan approval, along with your credit score. One rule of thumb is to try and keep your back-end DTI to 36%.
What Is an Income-Driven Repayment (IDR) Plan?
Student loan payments are part of how your DTI is calculated. This could be hard, though, because you can choose from several different federal student loan repayment plans that have vastly different monthly payments.
Some of your plan options are IDR plans. Income-driven repayment plans cap payments at between 10% and 20% of monthly income depending on the plan. The amount you will pay each month can change, as payments vary based on your current earnings.
Since your payment under an IDR plan can fluctuate, it may be difficult to determine what repayment amount to include when calculating your DTI. Also, mortgage lenders have different rules for how they determine your monthly student loan payment when you're on an income-driven plan.
How Different Loan Programs Calculate Income-Driven Payment Amounts
There are five main government entities that set rules for the mortgage programs they offer:
- Fannie Mae
- Freddie Mac
- Federal Housing Administration (FHA)
- U.S. Department of Agriculture
- U.S. Department of Veterans Affairs
Each entity treats monthly IDR payments differently when calculating a potential borrower’s DTI.
Banks, credit unions, and other mortgage lenders may have different rules for calculating DTI. Ask to speak to a loan specialist to understand how your IDR plan could impact your mortgage eligibility.
Fannie Mae's rules stipulate that the actual payment you’re making under an IDR plan is the amount that will be included in DTI calculations. This is true even if your payment on the student loan plan is $0. There must be documentation available showing that the payment is $0.
Freddie Mac's rules also allow your actual monthly payment to be used in calculating DTI ratio—unless that payment is $0 per month. If your payment is $0, then the number used in DTI calculations will equal 0.5% of your outstanding loan balance as stated on your credit report.
Federal Housing Administration (FHA)
FHA rules require that the monthly student-loan payment used for your DTI must equal one of these numbers:
- The greater of 1% of the outstanding loan balance or the monthly payment that's reported on your credit report
- The actual documented payment, as long as the loan will be fully repaid over the loan payoff term
If the actual documented payment is less than 1% of the outstanding loan balance or less than the monthly payment reported on your credit report, you must provide written documentation as to the monthly amount due, the payment status, and the outstanding balance.
If your documented IDR payment isn't large enough for the loan to be fully repaid by the end of the repayment period—which can happen with income-driven payments—then the FHA will default to the 1% rule or monthly payment listed on your credit report
U.S. Department of Agriculture (USDA)
The USDA also provides two options regarding how monthly student loan payments are determined for calculating DTI. When you’re on an income-driven plan and not making fixed payments, your monthly payment must equal the greater of:
- 0.50% of the outstanding loan balance as shown on your credit report
- The current documented payment under a repayment plan approved by the Department of Education
U.S. Department of Veterans Affairs (VA)
The VA requires that lenders use the loan payment amount on your credit report for your DTI. However, if that payment is below a certain threshold, the borrower must provide a statement from the student loan servicer detailing the actual loan terms.
The threshold calculation is 5% of the outstanding loan balance divided by 12 months. For example, if you owe $20,000, the calculation would be $20,000 x 5% = $1,000. Then $1,000 / 12, which equals $83.33.
Mortgages guaranteed by federal agencies often don't come directly from those agencies. Instead, they are issued by private lenders who must comply with requirements set by the agency backing the mortgage.
Understanding Your Lender's Rules on IDR Plans
When applying for a home loan, your DTI could make the difference between approval and denial. By understanding how different types of mortgage programs calculate DTI ratios and how your student loan IDR plan is factored in, you can decide which home loan program is best for you.