What is the debt to income ratio and why is it important?

When you approach a bank or a financial institution for a loan, the lending entity has one main concern — they need to ensure that you will repay your loan as per the repayment schedule. Your credit score is one of the main metrics that banks use to determine the possibility of you defaulting on the loan.

But having a good credit score alone is not enough. Banks also need to assess your repayment capacity. In other words, they need to make sure that you are financially capable of paying your loan EMIs promptly.

To verify this, banks and financial institutions make use of a metric called the debt-to-income (DTI) ratio.

What is the debt-to-income ratio?

The debt-to-income ratio is the ratio of all your monthly debt expenses to your gross monthly income. In other words, it is the percentage of your monthly income that goes towards repaying your debts.

The debts considered here include all kinds of liabilities, such as your monthly credit card payments, personal loan EMIs, car loan EMIs, home loan repayments and any other debts you may be paying off.

How is the debt-to-income ratio calculated?

The debt-to-income ratio is calculated using a simple formula, as shown below.

So, for example, let’s say you earn a gross monthly income of Rs. 1,00,000. And this month, you pay the following sums to settle your debts or liabilities.

• Home loan EMI = Rs. 20,000
• Car loan EMI = Rs. 6,000
• Credit card dues = Rs. 12,000

In this case, your total monthly debt payments come up to Rs. 38,000. This means your debt-to-income ratio will be calculated as follows.

DTI Ratio:

= (Rs. 38,000 ÷ Rs. 1,00,000) x 100

= 38%.

What is a good debt-to-income ratio?

Banks and other lenders look at your DTI ratio to determine how capable you are of repaying a new loan you take. As a general rule, the higher your debt-to-income ratio is, the more difficult it will be for you to repay a new debt. This is because a huge part of your income will already be going towards repaying your existing liabilities.

Here is a closer look at what different ranges of the debt-to-income ratio may indicate to a potential lender.

So, the bottom line is that it is advisable to keep your DTI ratio below 36%. That way, you will not be under any undue financial stress, and repaying your loans will be easier.

Why is the debt-to-income ratio important?

Your DTI ratio impacts several areas of your personal finance. It is one of the key metrics that determines many aspects of the credit facilities you are eligible for. Here are the key reasons your debt-to-income ratio is important.

• It determines your eligibility for new loans

A high debt-to-income ratio limits your eligibility for new loans and credit facilities. Lenders will consider your repayment capacity lowered because your current debt levels are high. On the other hand, if your DTI ratio is lower, you will find it easier to avail a new loan or apply for a new credit card.

• It plays a key role in the credit limits available to you

Even if you are eligible for a new loan or a credit facility, the DTI ratio will determine the maximum amount you can borrow. A high DTI ratio will result in lower credit limits, because lenders may not be sure if your current income may be sufficient to repay higher amounts of debts.

• It affects your financial goals

Many major financial goals like building your dream home, buying a new car or paying for your children’s education abroad may require external financing. Since your DTI ratio influences your eligibility for credit and the amount of loan that you can borrow, it eventually affects your ability to achieve your financial goals as planned.

How to improve your debt-to-income ratio?

Worried about your high debt-to-income ratio? Well, the good news is that there are some things you can do to bring your DTI ratio down to acceptable levels.

• Postpone inessential purchases
• Look for ways to supplement your primary income
• Avoid taking on more debt till your current loans are repaid

Additionally, you can increase the EMIs due on your personal loan or any other loan if possible. This may temporarily increase your DTI ratio, but will eventually help you close your loan faster. This, in turn, will lower your debt-to-income ratio again.

Conclusion

Now that you know what the debt-to-income ratio is and why it is important, you can work on keeping this number within the optimal range. You can calculate this ratio yourself, using the formula given above, or you can use a free online calculator to compute this number. Remember to revisit this metric every few months to ensure that your DTI ratio is below 36%.