What is Debt to Income Ratio and its Importance?
If you’re looking for a loan, you’ve probably come across the concept “Debt to Income Ratio”. Let’s take a look at what it means, and why it’s relevant to you.
Debt to Income Ratio definition
In simple words, your debt to income ratio is the amount of debt you have, as compared to your overall income. The debt to income ratio (or DTI) is one of the most crucial factors that a lender would consider while deciding whether or not to approve your loan application.
Your DTI value tells a potential lender about your ability to manage monthly expenses and repay loans, or even mortgages.
A low DTI value shows that you’re capable of managing your funds well, and that you’re not deep in debt at all. These are things that will help a lender trust you, making them more likely to grant you the loan you need.
Detailed description: What exactly is DTI?
Your debt to income ratio is more than just a simple measure of loans vs income. It can also include other vital statistics such as principal, taxes, insurance premiums, and various fees as well. When underwriters check your ability to pay back a loan, your DTI is the most important factor they consider
There are two types of DTI, called front end ratio and back end ratio. These are expressed together in the format A/B. For instance, if your front end ratio is 34%, and your back end ratio is 37%, your DTI is expressed as 34/37.
Debt to Income Ratio for Home Loan:
As far as home loans are concerned, you only need to look at the front end ratio.
This is the percentage of your gross income that is spent on housing costs: this can be your rent, if you’re a tenant, or property tax, mortgage premium and related interest rates, hazard insurance, and homeowners’ association fees, if you own your house.
This is the number lenders look at when you apply for a home loan, and keeping it low will help you get one quite easily.
Debt to Income Ratio for Personal Loan::
Personal loans do not have any specific purpose, and you can use them to fund anything from simple purchases to long trips.
As far as these loans are concerned, the back end ratio is the crucial number; this is the percentage of your gross income that you spend on recurring loan repayments of various types such as car loans and student loans, credit card payments, alimony payments, and legal judgements. Note that this includes loans covered by your initial DTI.
There are many choices when looking for a personal or home loan. If you want a good deal, your DTI is the crucial factor. Keeping your back end ratio low is, therefore, critical, when you’re looking to get a personal loan.
Are you now looking up ‘what is a good debt-to-income ratio for a business loan’? Read this informative blog “Debt-to-income ratio: The prime determinant of your Business Loan application” to understand the basics.
Importance of DTI
As you’ve probably realised by now, your DTI value is key in getting a loan sanctioned by the lender, especially if you want to apply at a leading company like Bajaj Finserv, which offers features such as 5-minute online approval, and partial prepayment on its loans.
But how much is good enough? Generally, a DTI of 36 is considered reasonably good by most lenders. As a low number shows proper balance between loans and earning ability, it is advisable to keep this number below 36 if possible. The lower you get it, the easier it’ll be for you to get your loan approved.
If your DTI rises above 36, you’ll be putting yourself in an unfavourable situation so far as loans are concerned. Once this happens, banks and other lenders tend to be hesitant about approving loans..
A DTI higher than 36% signifies to the lender that you’re inept at managing your finances, and will be incapable of managing your expenses and loans.
As far as mortgage loans are concerned, studies have shown conclusively that people with lower DTI’s are more likely to manage monthly expenses responsibly, and lenders understandably prefer it when you have a low DTI. Generally, 43% is the highest number your DTI can reach and still qualify for a mortgage.
Now that you understand how DTI works, and what its value should be ideally, you’ll need to know how to calculate your DTI—it’s a simple procedure.
How to calculate your DTI
Take all of your monthly debt repayments, and add them all up: include every single one, such as your mortgage (principal, interest, taxes, and insurance) and home loan payments, car loans, student loans, minimum monthly payments on your credit card debt, and any other loans you might have – this number is called your recurring debt.
Divide this number by your gross monthly income, which is your entire income, not just cash in hand.
Multiply the result by 100 – this is your Debt to Income ratio.
For instance, let’s say you earn a monthly salary of Rs.75,000 and pay Rs.9000 for mortgage, Rs.6500 on car loans, and Rs.8500 on other assorted loans. This would mean that your total recurring debt would be:
Your DTI would therefore be (25,000/75,000) = 0.33, or 33%
How to reduce your DTI
At this stage, you’ve learned how to check your DTI, and tell whether it’s at a good level. Let’s say you find yourself over the recommended limit – this isn’t the end of the world, there are a couple of techniques you can use to reduce your DTI. Below, you’ll find a list of these techniques:
Live within your means
You probably know that you’re supposed to “live within your means”, but what exactly does this entail? It’s as simple as living within 60% of your earnings. For instance, if you earn Rs.50,000, you should make sure you’re not spending more than Rs.30,000 each month.
Repay all your debts
It’s an unhealthy habit to allocate more importance for expenses than to paying back outstanding loans, i.e., if you put off paying back a loan just so you can buy a gadget you really want, you’re making a common, but easily avoidable, mistake. Do make sure you pay off your monthly dues before even considering other expenses.
Supplement your income
If you find yourself sinking into sub-optimal DTI values, you can curb this by boosting your income – this could mean working overtime, taking up a part time job, or using your hobbies as a source of income.
You now know what DTI is, why it’s important, how to check your DTI value, and how to reduce it. All that remains is for you is to use this information to make sure that your DTI is at a good range – you’ll have no problems when applying for a loan, be it a personal loan or a home loan.
“Do not save what is left after spending, but spend what is left after saving. If you buy things you do not need, soon you will have to sell the things you need.”