What is the Debt-to-Income Ratio?

The debt-to-income ratio (DTI) represents a borrower’s debt repayment capacity in relation to their total monthly income. Meaning, how much of a person’s monthly income goes into paying away their debts. This ratio helps the lender or a financial institution determine the borrower’s ability to repay the loans. A low ratio signifies that the debts are being paid on time. This attracts more lenders, as it shows the borrower doesn’t have too many debts. At the same time, a higher ratio is a sign of below-par financial health. This makes obtaining a loan difficult and expensive.

Debt-to-income ratio calculator

It may sound hard, but calculating DTI is simple. Add all your monthly debt payments and divide them by your monthly gross income. Gross income is the income you earn before paying taxes and other deductions. To calculate your monthly debts, add the following: monthly rent, EMIs, home/auto/medical loan, mortgage, credit card bills, and other debts.

For example, suppose your total monthly income is Rs. 1,50,000. Your total debt obligation for the month is 50,000. Then your debt-to-income ratio would be (50000/150000)*100 = 33.33%. This shows 33.33% of your income goes toward the repayment of debts.

What is a good debt-to-income ratio?

The lower the debt-to-income ratio, the better it is. This shows you have fewer debts to repay. Hence, this makes new loan approvals easier and quicker. However, a good debt-to-income ratio will differ from lender to lender. Generally, a DTI ratio of up to 40% is considered suitable for loan approvals. DTI ratios above 40% may get loans, but the interest charged would be higher. But keep in mind that this is just one of the many parameters for taking a personal loan.

What Happens When a Debt-to-Income Ratio is Too High?

A higher DTI ratio can impact your financial life in one or more ways. Let’s take a look at how it can affect you.

• When the DTI ratio is higher, it shows you are spending a larger part of the income paying off debts. This means there are fewer savings and investments.
• A higher DTI ratio lowers the chances of getting loans. This can be a problem in an emergency.
• Individuals with a higher DTI ratio can secure a loan, but the interest charged by the lenders is usually on the higher side.

How to Lower a Debt-to-Income Ratio

Having a good financial plan is important when it comes to lowering the debt-to-income ratio. You also need to be aware of your debts and expenses. A lower DTI ratio ensures that you might secure a loan in the future when it is really important.

Some of these steps might help in lowering your debt-to-income ratio and improving your credit score.

• Postpone a purchase if it isn’t an emergency. This will cut down on credit card bills. When there are fewer purchases on credit, it will lower the debt-to-income ratio of the individual.
• Stop taking on more debt unless your ratio falls below 40%. Pay off all your debts, if possible. Paying off debts helps improve your credit utilisation rate. This further improves your credit score.
• Closing previous loans can help as well. Some people combine all their multiple high-interest debts into one and consolidate them by taking a personal loan.
• Increase EMI payments to finish the debts quickly. This helps in the long run.
• Find additional sources of income, if possible. Finding a side hustle, taking online classes, or working on weekends can help increase income.
• Calculate the debt-to-income ratio every month. This helps in monitoring and understanding how the debt is being managed. One can find what is working in their favour to keep the DTI ratio low. It is also motivating to see the debts being managed in an organised way.

Why is the debt-to-income ratio important?

The DTI ratio helps the lender measure your loan repayment capacity. It tells how much of your monthly income is going toward clearing off debts. This also affects your credit score, which a lender considers while approving loans. A low debt-to-income ratio increases your chances of getting a loan.

A good DTI ratio signifies that the borrower’s financial health is in good shape. That means they are in a position to secure a new loan and will be able to repay it without defaulting.

Does the debt-to-income ratio impact the credit score?

The debt-to-income ratio does have an indirect impact on your credit score. A lender doesn’t know what your gross earnings are. So, they can’t make accurate calculations. But they do look at how much credit you have. They compare your credit card account balances with the sum of all the credit limits on your cards. A lender will be more interested in the debt history of the borrower than their income history. Nonetheless, to secure a loan smoothly, maintaining a healthy DTI ratio is as helpful as a healthy credit score.

Conclusion

To conclude, the debt-to-income ratio can benefit both the lender and the borrower. As it shows the relationship between a person’s income and debts, it can assist the lender in determining the borrower’s repayment capabilities. And as an individual, by calculating DTI, one can see their expenses and work on them. You can review your debts every month and find ways to lower them. This can be done by either managing your expenses or increasing your income. For more finance-related tips, you can go to Piramal Finance and read more blogs.