Debt to Income Ratio: Importance and How It Is Calculated

Besides credit score, debt-to-income ratio is another important factor in determining your overall financial condition. Calculating the DTI ratio helps determine how comfortably you manage your current debt and decide if applying for more credit is the right thing to do. When you apply for a new loan like a debt consolidation loan, lending institutions calculate your DTI ratio to determine your lending risk and repayment capacity. In the following sections, you will understand the DTI ratio, why it is important, and how to calculate it.

What Is a Debt-To-Income Ratio?

The debt-to-income ratio is a numeric value in percentage, measuring your debt repayment capacity in relation to your gross monthly income. Simply put, it is the total of your monthly obligations divided by your gross monthly income. Financial institutions use this ratio as a tool to anticipate your ability to pay monthly EMIs towards a new loan you seek. A high DTI ratio indicates low repayment capacity and vice versa. Ideally, your DTI ratio should be at most 40% when you apply for a new loan.

Why Is Debt-To-Income Ratio Important?

The debt-to-income ratio impacts various areas of your finances, determining your loan eligibility. A high DTI ratio lowers your eligibility for new credit facilities because lenders foresee a low repayment capacity due to high debt levels. Conversely, you can easily get more credit if your DTI ratio is low. The DTI ratio also determines your credit limit. If your current income is sufficient to repay higher debt amounts, you may be eligible to borrow higher amounts. While you may need external funding to study abroad, build a dream home, or buy a new car, a low DTI ratio will enhance your loan eligibility and affect your financial goals.

What Are the Limitations of the Debt-To-Income Ratio?

Although crucial, the debt-to-income ratio has some limitations as well. Let’s discuss them.

• DTI ratio is only one factor that lenders use to make their credit decision. They have several other parameters based on which they determine your eligibility, loan amount, interest rates, repayment terms, etc.

• The calculation does not distinguish different debt types and their servicing cost. For instance, your credit card might have a higher interest rate than your debt consolidation loan. However, you will lump together both while calculating the DTI ratio. If you take a low-interest loan to pay off the balance, your monthly payments will decrease, but the total outstanding amount will remain unchanged.

How to Calculate Debt-To-Income Ratio

Follow these steps or use an online debt-to-income ratio calculator to calculate your DTI ratio and make an informed decision regarding taking a new loan:

How to Lower a Debt-To-Income Ratio

If you have a high debt-to-income ratio, try reducing it to convince loan companies of your ability to take more financial obligations. Here’s what goes into reducing the DTI ratio to improve your position as a borrower:

Conclusion

While looking for a loan, you must do everything possible to keep your debt-to-income ratio low. It shows potential lenders that you have a good relationship with credit and know how to manage it well. It also indicates that you have a monetary cushion between your income and financial obligations to absorb any unforeseen expenses. Use an online DTI calculator to calculate this number and see how prospective loan companies perceive you. A Personal Loan EMI calculator online will calculate EMIs for a new loan, helping you make an informed borrowing decision according to your repayment capacity.

Frequently Asked Questions

A DTI ratio of 50% is not favourable for your loan application. Prospective lenders may see you struggling to meet your existing debt obligations. As a result, they may reject your loan application or offer a smaller loan amount at higher interest rates.

A DTI ratio of 20% indicates that you have enough monthly income to pay off your obligations and put towards savings and investments. Most loan providers will feel safe lending to you with an assurance of timely monthly payments.

A DTI ratio above 50% is a bad debt ratio that reduces your eligibility for more loans. A high debt ratio may also stretch your finances and make repayments challenging for you. So, try to increase your income or reduce your obligations to reduce your debt-to-income ratio.