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Debt-to-Income ratio is one the significant factors that determine your creditworthiness. To know more about this personal finance metric, check out this article!
Have you ever thought about applying for a loan or a credit card? Do you recall what criteria the lender used to determine your eligibility? While your income may play a role, it is not the only factor. In reality, before a bank makes a lending decision, they will assess your creditworthiness. This includes calculating your DIY debt-to-income ratio.
Well, in a more formal sense, before any bank finalises lending you any amount, the check for your creditworthiness.
This check for creditworthiness includes your income sources, possible collateral in case the loan is too big, and lastly, your debt statements.
The point of concern here is your ‘ability to pay back the loan’ taken by you.
Banks have enough NPAs to deal with nowadays and that makes them even more so when it comes to creating the bad credit- that is, lending to the wrong person.
Similar is the case for credit card companies. When you own a credit card, there are quite a few payments associated with it that are not bearable by everyone.
It makes it important for these companies and banks to check if you are a "worthy borrower’.
They have to ensure that you don’t carry a bag of debts while applying for their product.
Because if you do so, you will eventually end up skipping payments and making the situation worse for yourself and definitely create problems for them too.
One of the easiest ways to check your creditworthiness is the Debt-to-Income Ratio (DTI). Let's see what it actually means.
1. What is the meaning of the Debt-to-income (DTI) ratio?
The DTI ratio is a method to check your borrowing risk. It signifies the percentage of your gross monthly income that usually goes into the payment of debts.
The previous statement makes one thing clear- if this percentage of your gross monthly income going into debt repayments is high, then your debt liabilities are high. Is it good for your creditworthiness? Certainly not.
The higher it is, the higher would be the suspicion of the banks and definitely leser would be the chances of you getting the amount of your desired loan.
2. Understanding the DTI ratio- its significance for a borrower
If you have a low DTI ratio, it simply signifies a good balance between your debt and income.
That is, the income that you earn is not getting dumped into the debt pool, rather is actually being utilised somewhere else.
Conversely, a high DTI ratio would imply that your hard earned income is nothing but just a source of debt payments.
The DTI ratio not only signifies a percentage to determine whether you should be given a loan or not but it also estimates how much of an efficient money manager you are.
A typical belief is that any person with a low DTI ratio is capable enough to manage his/her monthly debts efficiently.
Therefore, banks wish to look at a low DTI ratio before lending money. This makes practical sense since it is profitable for banks to ensure that the borrower is not overextended- that is, doesn’t have too many debts.
If you are wondering what the maximum percentage share of debt that gets you qualified for a loan, let’s have a look at some general guidelines: A DTI ratio of around 43% is the ceiling level that you can possess and still get qualified for a mortgage.
Furthermore, most banks and companies generally prefer a DTI ratio that’s less than 36%. Out of that36% too, no more than around 28% should be going into a mortgage or rent related payments.
Remember that these ratios will definitely fluctuate from lender to lender. Therefore, don’t panic at these statistics. However, as already mentioned, the lower your DTI ratio is, the better.
3. How is the DTI ratio calculated? What is the formula?
Debt-to-Income ratio is nothing but a personal financial measure that compares an individual’s monthly debt payments to their monthly gross income.
So, you can divide your monthly debt payments by your monthly gross income and get your DTI ratio.
Your monthly gross income is the one which exists before you deduct any taxes or other payments from it.
4. Are there any limitations to the use of DTI ratio?
So far, you can at least conclude that the DTI ratio is an important financial tool. However, it is not everything.
By that, we mean that it is only one of the many measures of personal finances used by banks to make credit decisions.
Your borrowing history and credit history (& score) are other essential factors that will have to be considered before extending credit.
Since your DTI ratio is not a measure of distinguishing between the different types of debts that you hold or how you service them. But your credit history does everything more precisely.
In your DTI ratio, both credit card debt and student loans will be lumped together, despite the fact that the former holds more weight than the latter.
In order to get this ‘joint debt’ down, you can transfer your credit card balance to a low interest rate credit card and decrease your monthly payments.
Eventually, your monthly debt payments will fall and so will your DTI ratio- leaving the actual outstanding debt unchanged. Check how Credit Card works.
So you don’t have to worry too much about your DTI since it is only a metric used by banks to make a precise credit decision.
However, improving it is not a heavy task and would just simply make things much simpler for you.
A good DTI ratio can be helpful if you are struggling to get a loan. Despite the presence of other factors like credit score and history, DTI still has a huge role to play when it comes to making financial credit decisions.
Even if you don’t give it a high weightage, some other lenders may. Therefore, in order to ensure that you don’t lose your creditworthiness, the minimum you can do is to work on your DTI.
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