While applying for a loan, the bank assesses the borrower’s creditworthiness. This is done to ensure if the applicant would be able to repay the loan. A debt-to-income ratio or DTI ratio is one factor used by banks to determine whether or not to lend the loan to an applicant. To know more about the debt-to-income-ratio, read the article below:
Understanding the Debt-to-Income Ratio
The percentage of monthly income you use to pay your debts is referred to as your debt-to-income(DTI) ratio. DTI is an important metric used by lenders to assess your borrowing risk.
A low DTI indicates that you have balanced debts and income. Borrowers with low DTI are considered likely to manage their finances effectively. As a result, providers want to see low DTI ratios. However, the maximum DTI ratio may vary from lender to lender.
Types of Debt-to-Income Ratios
There are two types of debt-to-income ratios:
Front-end ratio
This ratio refers to the percentage of income spent toward mortgage, rent, property taxes and insurance.
Back-end ratio
This ratio refers to the percentage of income spent towards all recurring debt payments in addition to the expenses mentioned above. Some of the costs included in the back-end ratio are credit card payments, student loan, car loan, etc.
Calculating Debt-to-Income Ratio
DTI is calculated using the formula:
DTI Ratio = Total Monthly Debt Payments/Gross Monthly Income X 100
Where,
- Total Monthly Debt Payments is the sum of all EMIs and credit card payments
- Gross Monthly Income is your total income for a month
Example to Understand Debt-to-Income Ratio
Let us understand the debt-to-income ratio with the help of an example:
Mr X is trying to get a home loan, and for that, he needs to figure his debt-to-income ratio:
Mr X’s monthly salary is Rs. 50,000
His expenses are:
Car Loan EMI – Rs. 15,000
Credit card bill – Rs. 6,000 (approximately every month)
The total debt that he pays every month is Rs 21,000
Putting the numbers in the DTI ratio formula we get,
21000/50000 X 100 = 42
This means that the DTI ratio of Mr X is 42% which further implies that Mr X uses 42% of his monthly income to pay for his debts.
Suggested Read: What is LTV Ratio?
Word of Advice for Loan Borrowers
If your debt load is higher than what the lenders expect, it would be advisable to try and lower it to some extent. One of the most obvious ways of lowering your DTIs would be to reduce your total debt by lowering your expenditures or increasing your monthly income.
Addressing Some Common DTI Questions
What is a good DTI ratio?
The percentage of DTI ratio may vary from lender to lender. However, in general, a DTI ratio of up to 40% may be considered suitable for getting a loan approved.
What happens if my DTI ratio is high?
A higher DTI ratio reduces your chances of loan approval and tags you as a risky borrower. This means that the lenders are not sure if you will be able to repay the loan.
How can I lower my DTI ratio?
To lower your DTI ratio, you will have to manage your expenses or increase your monthly income.
How to calculate DTI Ratio?
To calculate your DTI ratio, you can use the formula: DTI Ratio = Total Monthly Debt Payments/Gross Monthly Income X 100. Another way to calculate the DTI ratio is to use an online calculator. Here you will need to fill in details such as your monthly debt payments and gross monthly income. Your DTI ratio will be displayed on your screens.
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