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Before lenders approve your loan, they will first look at your credit score, credit report, and also a very important factor, the debt-to-income ratio, commonly known as DTI. All of these criteria will show if you can repay what you borrowed. DTI is a ratio of debt relative to income and it will show whether you have the means to pay the loan.
Normally, lenders look at DTI to determine how much of your income goes to debts you already have. When your Debt-to-Income (DTI) ratio is low, it means you are making more money than what you owe. On the other hand, a high DTI implies that most of your salary goes towards debt repayment.
Debt-to-Income ratio is a metric that creditors use to evaluate an individual's capability of paying their debts and interest payments. It determines this by comparing an individual's monthly debt obligations against their total monthly income. In addition, many lenders look at DTI as a major factor when deciding whether they should lend you money or not. It assures them that borrowers can make regular repayments and take more debt if needed.
Your debt-to-income ratio (DTI) is a numerical representation of how your monthly debts compare to your gross income. As a percentage, this metric lets lenders evaluate whether you can effectively manage financial obligations and if they should approve a loan for you. Simply divide your monthly debts by the amount you earn a month to know where you stand.
In general, lenders view those with high Debt-to-Income (DTI) ratios as riskier borrowers since they may encounter problems while repaying the loan when they face financial hardship.
To calculate a borrower's DTI ratio, lenders use the front-end and back-end ratios. Let's take a closer look at each and how they are figured out:
It is also known as the housing ratio, front end debt-to- income ratio compares the individual's gross income to what they are spending on housing expenses. It is calculated as a percentage where you divide the housing expenses by gross income. The best front-end debt-to-income ratio shouldn't exceed 28%. The housing costs consist of only mortgage interests and payments. On the other hand, gross income is the total income earned, inclusive of taxes.
When lenders assess your creditworthiness, they'll use a Back-end Debt-to-Income (DTI) ratio to gauge how much of your gross monthly income is spent on debt repayment. To be considered for a loan, your back-end DTI needs to clock at 36% or lower. To calculate the back-end DTI, divide your total monthly debt expense by your gross monthly income, then multiply it by 100.
When calculating your total monthly debt expenses, you have to factor in payments for mortgages, credit cards, loans, and any other existing obligations.
For example, consider a person with a housing cost of INR 15,000, monthly debt expenses of INR 25,000, and a gross income each month totaling INR 60,000.
The Front-end DTI Ratio will be:
(Housing cost/Gross monthly income) * 100 = 25%
The Back-end DTI Ratio will be:
(Monthly debt expenses/ Gross Monthly income) * 100 = 42%
From this example, the borrower is competent enough to pay their housing expenses yet struggles with managing debt repayment in correlation with income. Due to this lack of efficiency, lenders may be wary about lending funds as they should consider the borrower's capacity for paying back what is owed.
When calculating the Debt-to-Income ratio, which assesses whether a person is a viable credit risk. You must factor in the monthly debt payments and the gross monthly income. This sum includes repayment of loans, insurance premiums, taxes, and other applicable fees against one's earnings before tax deductions. In India, an acceptable DTI ratio is about 40%; however, it is ideal if you have a lower DTI.
DTI ratio= (Monthly Debt Payments/Monthly Gross Income)*100%
Suppose Ken gets an income of Rs. 80,000 every month. For this amount, RS 25,000 goes to EMI for a car loan, and Rs. 15,000 is spent on an educational loan. This implies that half of the net income, which is Rs 40,000 every month, is for paying debts. In such a case, to calculate the DTI ratio, you have to divide the total debts (Rs. 40,000) by the monthly income he earns (Rs 80,000) and multiply by 100.
DTI= 40,000/80,000 = 0.2*100% = 50%
Lenders use Debt-to-Income (DTI) ratio to know the risk in granting you a loan. It is prudent to keep this number as low as possible for qualifying for a loan; most lenders use 43% DTI as their benchmark. DTI higher than that will prevent you from getting the loan. Mostly, a DTI ratio of 43% is the maximum value to be approved for a mortgage.
A Debt-to-Income (DTI) ratio of 50% is worrying. Such a DTI ratio implies that you don't have much money to spend every month, so making timely payments for the loan can be tricky. Having a DTI between 36 and 43 percent is considered good but still requires improvement before you apply for any loan. Consider lowering your DTI, as this will give you a high chance of getting approved.
If your Debt-to-Income ratio is below 35%, you're in a great spot and can easily handle any new debt and pay it on time. You'll be able to stay ahead of payments, so even if an unexpected cost comes up, you will still be able to handle the current bills.
Depending on your lender and the loan you acquire, the requirements for a debt-to- income (DTI) ratio can differ significantly. The DTI needed to achieve a mortgage may differ from what is required for obtaining a personal loan.
You may also read this: Mortgage loans
Your debt-to-income ratio is a critical part of your financial health and can determine the type of credit products you are eligible for. Here are a few essential reasons why this metric is important:
Having a higher debt-to-income ratio will reduce your eligibility to be approved for new loans and credit facilities. This is because lenders view you as having lower repayment capability with such high current debt levels. Conversely, if you have a lower DTI Ratio. It will be simpler for you to secure a loan or get accepted for applying for a credit card.
Regardless of whether you qualify for a loan, the DTI ratio will determine how much you can borrow. If your debt-to-income ratio is high, creditors will decrease your available line of credit as they may not be sure if your current income would be enough to repay more.
Achieving major financial objectives like constructing your dream home, investing in a new vehicle, or paying for education for your children abroad may necessitate external funding. Your debt-to-income ratio influences whether you qualify for credit and how much of a loan you can secure, thereby affecting your ability to meet the planned financial goals.
Don't let your high debt-to-income ratio bring you down. There are plenty of strategies to help lower this figure so that you can easily be approved for a loan. Here are a few things you can do to improve the DTI ratio:
If possible, try to increase the EMIs of your personal loan or any other loan. This may temporarily raise your Debt-to-Income ratio in the short term. Yet will help speed up repayment and lower this figure again over time.
In summary, understanding your debt-to-income ratio can be extremely advantageous for you. Use the formula above to check that this metric remains below 36%. This will enable you to control your finances and secure a good financial future.