Steps To Calculate Your Debt-To-Income Ratio

The debt-to-income ratio (DTI) is a financial measure used to assess an individual's monthly debt load compared to their gross monthly income. This ratio is crucial for lenders to determine your ability to manage monthly expenses and repay debts. DTI is calculated by dividing total monthly debt payments by your gross monthly income, expressed as a percentage. A lower DTI, ideally 30% or below, can help you secure loans more easily as it indicates a good balance between debt and income.

This article will guide you through the steps to calculate your debt-to-income ratio, its impact on obtaining personal loans, and tips to improve it.

Why does DTI matter?

When you apply for a new loan or credit, the debt-to-income ratio is a key indicator of your creditworthiness and financial stability for lenders. A lower DTI ratio suggests that your income is higher than your monthly debt, making you a less risky borrower. Meeting the overall eligibility criteria can lead to more favourable loan terms such as lower interest rates and higher borrowing limits. Conversely, a high DTI ratio might make lenders hesitant to offer credit, as it indicates a higher risk of defaulting on loan payments.

How to calculate DTI? Formula & step-by-step guide

Follow these steps to calculate your debt-to-income ratio:

1. Determine your total monthly gross income, which is your income before taxes and other deductions.
2. Total all your monthly debt obligations, such as credit card bills, EMIs on car loans, home loans, and other debt payments.
3. Apply the debt-to-income ratio formula, which is: (Total monthly debt payments / Monthly gross income) * 100.

Let us consider a simple example:

If your monthly debt payments total INR 10,000 and your gross monthly income is INR 40,000, your DTI ratio is:

10,000/40,000 * 100 = 25%

This means that 25% of your monthly gross income goes towards paying debts, and indicates that you are more likely to manage monthly payments effectively.

Factors that affect your debt-to-income ratio

Several factors can influence your debt-to-income ratio, impacting how lenders evaluate your financial health:

Income changes: Any increase or decrease in your gross monthly income directly affects your DTI ratio.

New debt: Taking on additional debt through new credit cards, loans, or other financial obligations will raise your DTI ratio.

Paying off debts: Reducing or eliminating debt lowers your DTI ratio, improving your creditworthiness.

Monthly expenses: Increases in obligations like rent, child support, or other recurring expenses can increase your DTI ratio.

Interest rates: Higher interest rates lead to higher minimum monthly payments on your existing debts, which can raise your DTI ratio.

What is a good debt-to-income ratio?

Different lenders may have different requirements for an ideal debt-to-income ratio. A good DTI ratio is typically 30% or lower. A DTI ratio of up to 49% might still be acceptable to some lenders. However, you might face stricter eligibility requirements or higher interest rates.

Ratios of 50% or higher are considered worrisome, as they suggest that half or more of your income is committed to debt, increasing the risk of defaulting on loans. 

The ideal DTI ratio can also differ slightly for specific types of loans such as home loans or car loans. Overall, a lower DTI ratio is crucial for obtaining favourable loan terms and managing financial health.

How to improve your debt-to-income ratio

Lowering your debt-to-income ratio can help lenders view your loan application more favourably and secure better loan terms. Here are some tips to achieve this:

• Seek ways to boost your monthly income, such as taking on a part-time job or freelancing.
• Focus on reducing your existing debt, especially high-interest loans and credit card balances.
• Try to avoid taking on any new loans or credit card liabilities that could increase your monthly payments.
• Manage your budget so as to cut non-essential expenses, freeing up more money to handle debts.
• Keep a close watch on incoming and outgoing expenses as well as the DTI ratio to make adjustments as needed.

Does my debt-to-income ratio affect my credit score?

Your debt-to-income ratio does not directly affect your credit score because it isn't included in the calculations made by credit reporting agencies. However, components that influence your DTI, such as your total debt levels and credit utilisation, are critical factors in determining your credit score. 

Credit scores are majorly influenced by how responsibly you manage your credit accounts, including timely payments and how much of your available credit you are using. Therefore, maintaining a low DTI can indirectly support a strong credit score, while a higher DTI can lead to a lower score.

Why is monitoring your debt-to-income ratio important?

Monitoring your debt-to-income (DTI) ratio is crucial because it provides a clear picture of your financial health and borrowing capacity. A low DTI ratio indicates that you are managing your debt well, which is preferred by lenders when you seek new credit or loans. 

Regularly checking your DTI ratio helps you make informed financial decisions, like when to cut back on spending or whether you can afford to take on new debt. It enables you to take timely action to improve your financial situation, ensuring that you maintain a balance that supports your financial goals.

Impact of personal loans on DTI

When you take out a personal loan, the regular repayment amount gets added to your monthly debt obligations. If your income does not increase correspondingly, your DTI ratio will rise. 

A higher DTI ratio can make obtaining future credit more challenging or expensive. On the other hand, if you use personal loans and manage repayments wisely, they can help maintain or even improve your debt-to-income ratio.

Personal loans can be used for debt consolidation. By consolidating high-interest debts (such as credit cards) into a single loan with a lower interest rate, you can potentially reduce your overall monthly debt payment.

Strategies for managing personal loan debt within DTI limits

Calculate DTI before taking the loan: Before taking out a personal loan, calculate your current DTI ratio. Ensure that the additional loan payment will keep you within acceptable DTI limits.

Borrow only what you need: Doing so will help you avoid unnecessarily increasing your debt burden.

Extend repayment terms: Negotiate with lenders for longer repayment terms to decrease monthly payments. However, this means you'll pay more in interest over the life of the loan.

Adjust your budget: Tighten your budget to increase the amount you can allocate to debt repayment, cutting unnecessary expenses. You can use an EMI calculator to plan your finances effectively.

Other strategies include avoiding taking new debt while you are paying off the personal loan, seeking additional income sources to help cover loan payments, debt consolidation, and prioritising paying off any high-interest rates debts first to reduce interest charges and overall debt burden.

Conclusion

A low debt-to-income ratio is crucial for ensuring financial stability and improving chances of loan approval with favourable terms. By employing strategies such as prioritising paying off high-interest debts, consolidating loans, and adjusting your budget, you can keep your debt levels manageable and within acceptable limits. Regularly reassessing your financial strategy will help you stay aligned with your financial goals. 

The ideal debt-to-income ratio for personal loans is 30% or below. If you are looking for tailored financial solutions, consider SMFG India Credit. We offer personal loans of up to INR 30 lakhs* with low-interest rates starting at 13%* per annum for eligible applicants. Use our personal loan eligibility calculator to get an estimate of the maximum loan amount you may qualify for. Apply online or contact us to know more!