Understanding Debt-to-Income Ratio: Definition, Calculation, and Importance

Lenders will lend you money until you can pay them back. The debt-to-income ratio is the tool they use to assert your repayment capabilities

Banks evaluate borrowers’ creditworthiness when assessing instant personal loan applications. The process is vital as it provides certainty that borrowers will be able to pay back the loan. There are many components in the process, but none is as important as the debt-to-income ratio, or DTI ratio. A crucial part of the credit assessment process, the debt-to-income ratio tells banks your capability of repaying the loan. Read on to learn more about what is the debt-to-income ratio, and what it does.

What is the debt-to-income ratio?

The debt-to-income (DTI) ratio is the percentage of your monthly income that you use to pay your debts. Banks use the debt-to-income ratio to measure your borrowing risk.

A low DTI ratio suggests that your debts and income are in balance. Borrowers with a low DTI ratio are better at handling their finances. Banks, hence, prefer borrowers with low DTI ratios.

Types of Debt-to-Income Ratios
 

1. Front-End DTI Ratio
   
   Definition - To calculate the front-end DTI, add up your expected housing expenses and divide it by how much you earn each month before taxes (your gross monthly income). Multiply the result by 100, and that is your front-end DTI ratio.
   
   
2. Back-End DTI Ratio
   
   Definition - How to Calculate a Back-End Ratio. The back-end ratio is calculated by adding together all of a borrower's monthly debt payments and dividing the sum by the borrower's monthly income and multiplying by 100.

How do we understand the debt-to-income
ratio?

A low debt-to-income ratio indicates that your debt and income are in balance. If your DTI ratio is 15%, it means that 15% of your total monthly income is used to pay debt each month. A higher DTI ratio, meanwhile, indicates an individual’s income is unable to address their debt.

Individuals with low debt-to-income ratios are more likely to keep up with their monthly debt payments. Therefore, banks and financial credit providers look for low DTI ratios before giving a loan to a potential borrower. Lenders favour low DTI percentages because they want to ensure a customer is not overstretched.

What is the debt-to-income ratio formula, and how is it calculated?

The debt-to-income (DTI) ratio reflects an individual's monthly loan payment to their monthly gross income. Your gross earnings is the amount you earn without taxes and additional deductions. The debt-to-income ratio is the proportion of your monthly gross income that goes toward debt payments.

The debt-to-income ratio formula is:

DTI ratio = Total monthly debt payments/Gross monthly income X 100

where: Total monthly debt payments are the aggregate of the monthly EMIs, including credit card payments. The gross monthly income is the sum of your monthly earnings.

How does the debt-to-income ratio affect credit score?

Your debt-to-income ratio has no bearing on your credit scores; credit bureaus may be aware of your income, but it is not factored into their calculations. Your credit scores are affected by your credit usage ratio or the amount of credit you are using relative to your credit limitations.

Credit reporting agencies are aware of your credit limits, both on individual cards and overall. Most experts recommend that you maintain your card balances under 30% of your entire credit limit. The lower the number, the better.

How to work with the DTI ratio?

Your DTI ratio can assist you in determining how to manage your debt and whether you have an excessive amount of debt.

A general rule-of-thumb breakdown is as follows:

• If your debt-to-income ratio is less than 36%, your debt is probably manageable. You should have no trouble getting fresh credit lines.
• If your debt-to-income ratio is between 36-42%, lenders may be concerned, and you may have problems borrowing money.
• Paying down 43-50% of the debt may be challenging, and some creditors may turn down any requests for additional credit.
• If your DTI ratio is greater than 50%, paying off your debt will be difficult, and your borrowing alternatives will be limited.

Borrowers must know about their debt-to-income ratio. If your debt is high, consolidate it through a personal loan from IDFC FIRST Bank. You can apply for a personal loan online and use the amount to lower your debt. A single loan is better for your credit than multiple loans. With IDFC FIRST Bank’s low interest rates Personal Loan EMI Calculator and easy payback option, you can significantly improve your DTI ratio. For an online personal loan application process, you can use some of the best lending apps, such as the IDFC FIRST Bank’s Mobile Banking App.

Disclaimer

The contents of this article/infographic/picture/video are meant solely for information purposes. The contents are generic in nature and for informational purposes only. It is not a substitute for specific advice in your own circumstances. The information is subject to updation, completion, revision, verification and amendment and the same may change materially. The information is not intended for distribution or use by any person in any jurisdiction where such distribution or use would be contrary to law or regulation or would subject IDFC FIRST Bank or its affiliates to any licensing or registration requirements. IDFC FIRST Bank shall not be responsible for any direct/indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information mentioned. Please consult your financial advisor before making any financial decision.