Published on : June 24, 2024
While applying for a loan, lenders consider several factors to ensure that you’re a responsible borrower who can comfortably repay the debt. Lenders will only lend you money when they know you can pay them back, but how do they make sure? That’s where the debt-to-income ratio (DTI) comes in.
It’s a factor that lenders consider to assess your repayment capabilities, and having an understanding of it can be beneficial for your financial situation.
Read on to understand what Debt to Income Ratio is, its importance, and how to calculate it.
What is the Debt-to-Income (DTI) Ratio?
The Debt to Income (DTI) ratio is a financial metric that compares an individual’s monthly debt payments to their gross monthly income. Lenders commonly use it to assess a borrower’s ability to manage monthly payments and repay debts.
A lower DTI ratio indicates a healthier balance between debt and income, suggesting that the borrower is more likely to manage their debt payments effectively.
Conversely, a higher DTI ratio may indicate that the borrower has too much debt relative to their income and may have difficulty managing their obligations. Generally, lenders prefer a DTI ratio of 36% or lower.
Importance of Debt to Income Ratio
The Debt to Income (DTI) ratio is important for several reasons:
Lending Decisions
Lenders use the DTI ratio to evaluate a borrower’s ability to manage monthly payments and repay debts. It is an important factor in the approval process for mortgages, car loans, personal loans, and credit cards.
Interest Rates and Loan Terms
DTI is one of the important factors in deciding the loan terms. Borrowers with lower DTI ratios are usually offered better interest rates and more favorable loan terms because they are perceived as less likely to default on their loans. Conversely, a higher DTI ratio can lead to higher interest rates and less favorable loan terms due to the increased risk to the lender.
Financial Health Indicator
The DTI ratio is a good indicator of an individual’s financial health. It helps individuals understand their debt levels relative to their income and assess when they’re deep in debt.
Budgeting and Planning
By calculating and understanding their DTI ratio, individuals can create more realistic budgets and financial plans. This helps them recognize the portion of their income that goes towards debt repayment and allows them to plan for repaying their debt sooner, which can consequently reduce their debt over time.
Meeting Lender Requirements
Lenders usually prefer a DTI ratio of 36% or lower for various types of loans.
Risk Management
For lenders, the DTI ratio is a risk management tool. It helps them assess the likelihood of loan repayment and reduce the risk of default.
How is the Debt to Income Ratio Calculated?
The Debt-to-Income (DTI) ratio is calculated by dividing an individual’s total monthly debt payments by their gross monthly income and multiplying the result by 100 to get a percentage.
Here’s a step-by-step explanation of how to calculate it:
Step 1: Determine Total Monthly Debt Payments
Include all your recurring monthly debt obligations, such as mortgage or rent payments, car loan payments, student loan payments, credit card payments (usually the minimum payment due), personal loan payments, and any other debt payments.
Step 2: Calculate Gross Monthly Income
Gross monthly income is the total income earned before taxes and deductions. This includes salary or wages, bonuses and commissions, overtime pay (if regular), pension, and any other sources of regular income.
Step 3: Apply the Formula
Use the following formula to calculate the DTI ratio:
DTI Ratio = (Total Monthly Debt Payments Gross Monthly Income) x 100
Let’s understand the DTI calculation with an example:
Step 1: Determine Total Monthly Debt Payments
- Home Loan EMI: ₹30,000
- Car Loan EMI: ₹8,000
- Education Loan EMI: ₹4,000
- Credit Card Minimum Payment: ₹3,000
Total Monthly Debt Payments = ₹30,000 + ₹8,000 + ₹4,000 + ₹3,000 = ₹45,000
Step 2: Calculate Gross Monthly Income
- Salary: ₹1,20,000
- Bonus: ₹10,000
Gross Monthly Income = ₹1,20,000 + ₹10,000 = ₹1,30,000
Step 3: Calculate DTI Ratio
DTI Ratio =45,0001,30,000100
DTI Ratio ≈ 34.62 %
This percentage indicates that 34.62% of the individual’s gross monthly income is used to cover debt payments, which can help lenders assess their creditworthiness.