What is Debt-to-Income Ratio in Student Loan Refinancing?

What is Debt-to-Income Ratio in Student Loan Refinancing

You might have heard about ratios if you ever covered accounting classes in course programs. Many students learn about such ratios and their interpretations in higher education classes. However, once they graduate, they realize the importance of these indicators. 

One of such important ratios is Debt-to-Income. Specifically, borrowers of student loans should be well aware of this tool and its effect on their borrowing ability. If they want to decrease the debt burden through student loan refinance, the Debt-to-Income ratio will gain even more significance. 

This guide will explain the refinancing process and how the Debt-to-Income ratio plays a huge role in personal finance. 

What is Debt Refinancing?

Student loan refinancing is a debt management technique that involves getting a new loan to cover existing ones. Usually, people use this method because the new loan provides better terms. For example, a refinancing loan can require a lower monthly payment than the total payments of existing loans per month. 

Another reason for this technique’s popularity is that it can cover many types of loans. While the government provides multiple options to federal student borrowers, it does not help private debtors much. If you have private loans, you have only a few options to reduce or eliminate the debt. Luckily, student loan refinancing is one of these options provided by private organizations.

Why Do People Get Rejected?

The student loan refinancing companies require several eligibility conditions to guarantee their debt payments. Those requirements are a high credit score, stable income level, reasonable Debt-to-Income ratio, and sometimes, a co-signer. 

In general, borrowers with more than 600 credit scores are eligible for refinancing services. They should also have a stable income with a reasonable Debt-to-Income ratio to ensure future payments. Lastly, a co-signer is a third party who can back up the debt payments if the original borrower fails to meet the obligations. When applying for refinancing service with a co-signer, all the eligibility requirements become applicable to the third-party, too. 

According to recent research, a quarter of student loan refinancing applicants get rejected. There can be multiple reasons for the denial. However, the most important reason for rejection is the high Debt-to-Income ratio. Around 26% of rejections were due to this cause. Other reasons included bad credit history or incomplete application with approximately 24% and 17% of failures, respectively. 

What Is Debt-to-Income Ratio?

But what is the Debt-to-Income ratio, and why do people fail to meet this condition? The Debt-to-Income ratio is an indicator that lenders use to assess borrowers’ ability to meet debt obligations. In other words, lenders check if the debtor can meet more debt payments in addition to what they currently pay. 

The simple way of calculating this ratio involves dividing the total monthly debt payments by gross income per month. The numerator – monthly debt payments- usually involve a car, mortgage, student loans, as well as credit card payments. The denominator- gross income- does not involve income tax and other deductions. 

Let’s see a calculation example. Assume you are generating $84,000 gross income yearly. Your debt payments are as follows:

  1. Student Debt: $400
  2. Mortgage: $1,500
  3. Car Loan: $320
  4. Credit Card: $180

In this case, your total debt payment per month is the sum of the above-mentioned elements, which is $2,400. On the other hand, monthly gross income is the yearly gross income divided by 12, which is $7,000. Hence, you need to divide $2,400 by $7,000 to get the Debt-to-Income Ratio. In our case, this ratio is approximately 34.3%.

How-to-get-student-loans

How to Evaluate the Ratio?

Knowing the ratio calculation is not enough to assess the borrower’s financial condition for the refinancing. You need to do ratio analysis and compare the level acceptable for student loan refinancing services. 

In general, the lower the ratio, the higher your chance of getting accepted, considering that other eligibility conditions are satisfactory. A low ratio shows that the borrower has the ability to make new debt payments due to the income left after paying the existing debt. A higher ratio is not desirable as it indicates that there is not much ability for the debtor to take on more debt.

In some cases, a higher ratio might not affect eligibility. In other words, you can still qualify for a student loan refinancing service. However, it will affect the interest rate you qualify for. Usually, risky borrowers with a higher Debt-to-Income ratio will get a higher interest rate than others with low ratios. In such a case, refinancing might not even benefit the debtor if the monthly payments become more than what they currently pay. 

What is the Reasonable Level of Ratio?

Each lender has its own conditions and acceptable level of the ratio. It is possible that they can consider additional elements in the calculation. Therefore, it can be hard to mention one percentage which will qualify the debtors. However, typically, the ratio of less than 36% is a good sign. If you have a higher ratio, you need to take some actions to lower it. 

How to Improve the Ratio?

Whether you want to improve your Debt-to-Income ratio or get refinancing services with low ratios, several methods can help you. 

  1. Contact the Lender

If your Debt-to-Income ratio is higher than the acceptable level provided by lenders, you can contact them directly. Some lenders will agree to refinance even with low ratios if they can secure the debt payments with other methods. They might ask for a higher interest rate, a co-signer, collateral, etc. Alternatively, you can do thorough research among lenders with the aim of finding a service provider suitable to your ratio level. 

  1. Decrease the Debt Payments

As the ratio’s numerator is debt payments, decreasing this amount will result in a lower ratio rate. Hence, you can get rid of some debt payments. For example, you can cover the credit card debt to decrease your ratio. You can start with the lowest amount of debt first and gradually pass to the other obligations. While aiming to eliminate some debt, you need to be careful to stop adding new debt. It can be hard to achieve, but keep in mind that once you get the help of refinancing, your monthly payments can decrease further.

  1. Increase Income Level

It might be obvious, but it is worth mentioning that an alternative way for a lower ratio is increasing the gross income per month. For example, you can talk to the manager about your options. Maybe you can find another internal position with a higher salary. Sure, it is always beneficial to find a better-paid job. Yet, if you tried an application to refinance before and failed, you can reapply once you get a better job. 

  1. Contact a Debt Expert

If you do not qualify for refinancing services, you might start looking for alternative options to reduce debt obligations. Consolidation services, negotiations with the lenders can be as useful as refinancing for private borrowers. For federal student loan borrowers, discharge, forgiveness programs, as well as diverse repayment plans, exist. It might be a good time to contact a debt specialist like Student Loans Resolved and get familiar with your options.

Final Words

If you want to get refinancing services, you need to have a full grasp of eligibility conditions. One such condition is the Debt-to-Income ratio, which indicates the borrower’s ability to take on more debt. First, calculate your option and decide if you need to improve it. In case of a high ratio, you might still find a service provider but with a high-interest rate. If you want to decrease the ratio, you can lower debt payments or increase income. Alternatively, borrowers unable to get refinancing services can explore their other options.

References: 

https://www.forbes.com/sites/taramastroeni/2020/02/07/approximately-25-of-refinance-applications-get-denied-each-year-heres-what-you-can-do-to-increase-your-odds-of-being-approved/?sh=3b5aa0a14cf6

https://files.consumerfinance.gov/f/documents/cfpb_your-money-your-goals_debt_income_calc_tool_2018-11_ADA.pdf

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