Understanding Debt to Income Ratio

When you apply for a new loan, the lender checks your debt-to-income ratio to decide whether you should get the loan or not; and if you do, then what should be the terms and conditions of the loan.

mymoneykarma is here to tell you all about debt-to-income ratio, how to calculate it manually, and how it can affect your credit health. We have also gathered some useful tips on reducing your DTI. Read on to know more.

What is Debt-to-income Ratio?

Debt-to-income ratio, or DTI, is a quantifier that lenders use to determine if a potential borrower is eligible for a new line of credit. It is an analysis of an individual's monthly income and existing debt obligations to find out if the individual is capable of handling and repaying more debt.

Your debt to income ratio doesn't affect your credit score. You can breathe a sigh of relief. In fact, your debt to income ratio doesn't even appear on your credit report.

When you apply for a new loan, the lender typically asks for a self-reported estimate of your salary or a document like your salary slip to confirm your income. The lender calculates your DTI and decides whether or not to sanction the loan accordingly.

Therefore, though it doesn't affect your credit score, it has a significant impact on your credit health as it decides your ability to get credit.

How is Debt-to-income Ratio Calculated?

Although there are many DTI calculators available online, let me show you how to calculate it manually.

1. Step 1: List your monthly loan payments. For Example,
   Car loan: Rs.10,000
   Study loan: Rs.15,000
   Credit card debt: Rs.5,000
   Total debt: Rs.30,000

2. Step 2: Divide the total debt by your total income
   Total debt: Rs.30,000
   Total income: Rs.90,000

   Calculating DTI:

   (Rs.30,000 / Rs.90,000) x 100 = 33.33%

   DTI = 33.33%

   This calculation helps you understand how comfortable a new debt load would be for your monthly income.

How Does Debt-to-Income Ratio Affect Your Credit?

Although DTI doesn't affect your credit score, it is important for your credit history. When you apply for a lump sum loan such as a mortgage or a car loan, the lender scrutinizes your debt to income ratio to evaluate and ascertain that you will be able to repay your debt. If you seem to be a high risk, lenders will typically impose an exorbitant rate of interest.

A high debt-to-income ratio indicates a risky borrower who does not have enough portion of his income left to accommodate a new debt obligation. On the other hand, if you have a low DTI, it reflects your ability to afford another debt - lenders trust you with more credit as you appear to have enough money to repay the amount.

What is the Ideal Debt-to-Income Ratio?

Financial experts recommend that a debt-to-income ratio less than 36% is ideal. Anything above that can be risky as you would most likely be denied a loan altogether or get a loan at a very high rate of interest. A debt-to-income ratio between 37% and 39% is risky, but you could still manage to get a loan.

However, if your debt-to-income ratio touches 43%, you should know that you have too much debt and you are no longer capable of accommodating another debt on your income level. You are spending close to half of your monthly income on debt and it's high time to re-think your financial situation.

Impacts of a High Debt-to-Income Ratio

If you have a high debt-to-income ratio, it can have a negative effect on your finances in multiple ways:

1. You will struggle to make ends meet because you would be using a considerable portion of your monthly income to repay debt.

2. It will be very difficult for you to get a new loan.

3. If you get a new loan, it would have a high rate of interest.

4. You might lose your ability to repay and sink into delinquency.

5. Your credit score might suffer as a result.

How to Reduce Your Debt-to-Income Ratio

Mymoneykarma has a few useful tips to reduce your debt-to-income ratio. If you wish to maintain a steady and low debt-to-income ratio, you could do the following:

1. Payoff your existing debt as quickly as possible. Add an extra amount to your current monthly loan repayment installment. Your DTI might increase initially, but it will certainly come down in the long run as you reduce the debt.

2. Look for ways to increase your income. You could take up a second job or you could ask for a raise. If your income level increases, your DTI goes down.

3. Avoid adding to your debt. Do not apply for new loans. Not only will your DTI rise, but you will be in a severe financial crunch.

4. If you have plans for a financially-heavy purchase, postpone it till your DTI comes down a bit. It will be difficult to get more credit when you already have a high DTI.

5. Recalculate your debt-to-income ratio every month to check your progress. This will keep you alert as well as serve as a motivation.

To Sum Up

Debts could be dangerous, especially if your income isn't sufficient to support all your debt obligations. Knowing your debt-to-income ratio can help you foresee your ability to deal with your debt.

Along with your credit score, also check your DTI before considering a new loan and decide wisely so that your financial health doesn't take a blow. Once your DTI is on track, you can apply for a loan at once.