Debt-to-Income Ratio: Beginner's Easy Guide For Home And Personal Loans
When navigating a home or personal loan, one of the most important metrics you will come across is the Debt-to-Income (DTI) ratio. It’s a straightforward financial health check done by lenders to see how well you can manage a new loan.
Understanding this ratio is useful for getting a loan approved hassle-free. It is also about gaining a clearer picture of your own financial standing. Learn how to calculate it in a few easy steps and understand why it carries so much weight when borrowing.
What is Debt-to-Income (DTI) Ratio?
It is a key parameter for all types of loans. It gives a clear picture of your total monthly debt payments compared to your total monthly income. Lenders determine the debt-to-income ratio to assess if you can afford to pay the new loan’s EMIs based on your disposable income.
Importance of Debt-to-Income Ratio
The DTI ratio is essential for evaluating financial well-being and managing credit. Lenders utilise it to assess risk. How? A small ratio demonstrates financial agility and reflects enhanced creditworthiness and vice versa. This may result in quicker loan approvals and better interest rates.
Example:
Say Riya and Raj are two potential borrowers applying for a personal loan of ₹1 lakh. Riya’s DTI is 30%, which means one-third of her income goes in servicing existing debt. Raj’s DTI is 50%, which means half of his income is used up in existing EMIs.
Keeping all other eligibility criteria the same, lenders will be more likely to approve Riya’s loan application and reject Raj’s application. After all, Riya seems to have more financial flexibility and is a low-risk choice as compared to Raj.
How to Calculate Debt-to-Income Ratio
To calculate the debt-to-income ratio, first find the sum of all your monthly debt payments. This includes EMIs for loans, credit card minimum payments, rent or mortgage, and any other recurring debts.
After that, calculate your gross monthly income, which is your income before taxes, including salary, bonuses, rental income, and other sources. Using these two numbers, you can apply the debt-to-income formula:
The calculated number is your DTI ratio.
Debt Payments to Include
To get the right percentage using the debt-to-income formula, include:
Note: This does not include variable expenses like groceries, utilities, or insurance premiums.
Gross Monthly Income
For the debt-to-income ratio formula, gross monthly income should include:
DTI Formula with Example
Say your gross monthly income is ₹50,000. If your total monthly debt payments are ₹20,000, your DTI will be as follows:
This means 40% of your income goes toward debt payments.
Debt-to-Net-Income Ratio – A More Accurate View
The debt-to-net income ratio offers a more precise view of your repayment capacity compared to the standard DTI. This is because it uses your gross monthly income, which is income after taxes and deductions.
However, the debt-to-income ratio is computed using your net monthly income. This is the amount that you get in your bank account before all deductions. Thus, net income represents your actual disposable income. As a result, the ratio becomes more accurate when measured using the net income you take home.
For instance, assume your salary is ₹80,000, but after taxes, your net monthly income is ₹60,000. If your debt payments are ₹24,000, your debt-to-net income ratio is 40%. This provides a clearer picture as compared to 30%, which is the result with the gross salary.
How to Lower Your Debt-to-Income Ratio
The easiest way to fix your DTI ratio is to take control of your finances. Focus on reducing debt and growing your income to lower your DTI effectively.
5 Effective Ways to Improve Your DTI
Here are 5 tips for a better DTI ratio, which helps to improve your loan eligibility.
One option is to ask your employer for a salary hike. You can also consider working as a freelancer or taking side jobs, if possible. This helps boost your earnings and helps lower your debt-to-income ratio.
Cutting your debt is the best option for overall financial well-being. You can either opt for avalanche (highest interest first) or snowball (smallest debt first) strategies, based on what suits your budget better.
Avoid making significant purchases or taking new loans or credit cards until you have a better DTI ratio.
Pay off most of your debts by taking on a single loan with reduced interest rates. This helps simplify payments and reduces monthly commitments.
You can reevaluate your DTI every month using the simple debt-to-income formula or an online calculator. This way, you can ensure that you are on top of your financial health and make timely adjustments to improve your creditworthiness.
By consistently applying these strategies, you can achieve a healthier DTI, making it easier to qualify for a loan and maintain long-term financial stability.
Final Thoughts: Why Tracking Your DTI Matters
Tracking is crucial to take charge of your finances and make sound borrowing decisions. By reducing this ratio, you can improve your chances of receiving loan approval faster. To successfully minimise your DTI, prioritise debt reduction, and increase your income.
Frequently Asked Questions
1. Ideal Debt-to-Income Ratio: What’s a Good DTI?
A DTI ratio under 20% is considered ideal for borrowers with a strong credit profile. However, getting a loan with a ratio between 20% and 35% is also possible.
2. Why is the DTI ratio important when applying for a loan?
Your DTI ratio shows lenders what percentage of your monthly income goes toward paying debts. A lower DTI demonstrates your ability to manage credit well and take on new debt, making you a less risky borrower and increasing your chances of approval.
3. What are the guidelines for DTI?
In India, lenders generally prefer a DTI ratio below 40%. A lower DTI, ideally under 36%, indicates you can comfortably manage new debt and increases your loan approval chances. Ratios exceeding 50% are considered high-risk, suggesting that a large portion of your income covers existing debts.
4. How to reduce DTI ratio?
To lower your DTI ratio, focus on two key areas: increasing your gross monthly income and reducing your total monthly debt payments. Consider a side hustle or asking for a raise to boost your income. To cut debt, prioritise paying off high-interest loans, avoid new debt, and consider debt consolidation.
5. How does DTI differ from Loan-to-Value (LTV) ratio?
DTI ratio dictates your risk as a borrower by showing lenders how much you are currently paying towards loans and what you can afford to add on. On the other hand, the LTV ratio is the