The debt-to-income ratio is used to determine a borrower’s repayment capacity by evaluating their monthly income. In other words, it’s a financial ratio that lenders use to determine a borrower’s ability to repay a loan. It is a tool used by banks and financial institutions to verify the borrower’s ability to make monthly payments for their debt.
In this blog, we will get to know what is Debt-to-Income and types of Debt-to-income ratio.
What is Debt-to-income ratio?
Debt-to-income ratio is expressed as a percentage by calculating your monthly debts to your monthly income. It is a financial metrics tool that lenders use to evaluate how much debt burden a borrower can reasonably take on. It helps borrowers as well as lenders to assess your financial stability.
Why does your debt-to-income ratio matter to lenders?
Most lenders offer personal loans with high debt-to-income ratios to determine how much debt the borrower can handle. Individuals with excellent credit scores, consistent income, and a decent payback history are ideal, but monthly debt repayments that consume a large part of your income may be considered a bad debt-to-income ratio. Banks and financial institutions may consider risk while extending your loan amounts.
There are two types of Debt-to-income ratio :
Front-end ratio:
It is also called a housing ratio that involves your housing expenses like property taxes, mortgage payments, and other housing-related expenses. Front-end ratio is calculated by housing cost relative to the borrower’s monthly income.
Front-end ratio = total housing ratio / Gross monthly income
Back-end ratio:
The back-end ratio compares all recurrent monthly debt commitments to gross monthly revenue. This indicates how much of your salary covers all monthly debt obligations, such as housing expenditures, home loans, and personal loans. It’s calculated as
Back-End Ratio = Total Monthly Debt Payments / Gross Monthly Income
What is a good debt-to-income ratio?
Front-end DTI ratio:
As a borrower, front front-end ratio should be maintained at 28% or less considered good. This shows the housing cost is not more than 28% of your monthly gross income.
Back-end DTI ratio:
If your monthly gross income covers all your back-end ratios like home loans, personal loans, and other housing expenses within 36% or less is considered as good.
While the above-mentioned DTI ratios are basic recommendations, the acceptable debt-to-income ratio limit can vary depending on the unique lender’s regulations, the loan program’s requirements, the applicant’s credit score, and other pertinent circumstances.
Maintaining a lower DTI ratio not only boosts the likelihood of mortgage approval but also positions borrowers favorably for more competitive interest rates, resulting in significant cost savings over the loan’s lifespan.
How to calculate your debt-to-income ratio
| Item | Amount (INR) |
| Gross Monthly Income | 75,000 |
| Monthly Debt Payments | |
| Rent | 20,000 |
| Car Loan | 8,000 |
| Credit Card Minimum Payment | 5,000 |
| Personal Loan | 7,000 |
| Total Monthly Debt Payments | 40,000 |
| DTI Ratio Calculation | |
| DTI Ratio = Total Monthly Debt Payments / Gross Monthly Income | 40,000 / 75,000 = 0.53 or 53% |
In this example, the individual’s total monthly debt payments are ₹40,000, and their gross monthly income is ₹75,000.
The DTI ratio is calculated as: DTI Ratio: Total Monthly Loan Payments / Total Monthly Income. = ₹40,000 / ₹75,000 = 0.53 or 53%
Conclusion:
Understanding your debt-to-income ratio is an essential part of financial literacy. It has an impact not just on lending decisions, but also on your financial wellness.
Calculating and controlling your DTI can help you achieve a more secure financial future and make educated decisions about taking on new debt.
Also Read:
How to get a credit card with a low CIBIL score?
FAQ:
Is 75% a good debt ratio?
Calculate the ratio between your monthly income and debt. A debt ratio of less than 30% is considered excellent, whereas a debt ratio greater than 40% is bad.
What is a bad debt-to-income ratio?
According to the lenders, a debt-to-income ratio is more than 40% can be qualifies as bad debt ratio.
How to calculate debt ratio?
The DTI ratio is calculated as:
DTI Ratio: Total Monthly Loan Payments / Total Monthly Income
What is a good debt?
A good debt might be based on borrower needs, such as purchasing products to save money and time, educational purposes, or debt consolidation.
How much debt is safe?
The debt-to-income ratio can be expressed in percentages. A decent debt is less than or equal to 30%. However, more than 40% can be considered excessive debt.
