Debt-to-Income Ratio: What is the Debt to Income Ratio?
What is the Debt-to-Income Ratio?
The debt-to-income ratio is an important ratio to ascertain creditworthiness.
It is used by banks and lenders to find out if it is feasible to grant loans to a particular individual.
A person with a low debt-to-income ratio (DTI) is an ideal client for banks and lenders.
Governments, too, keep an eye on the average DTI of its citizens to ensure that rising interest rates do not increase their debt burden.
DTI has been increasing across the globe over the past few years due to the shift towards consumerism, easy loans, and multiple payback options.
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This has led people to spend more and save less; ultimately resorting to credit, to fund their purchases.
Canada has been witnessing an increase in DTI, as well.
As of today, Canadian households are reflecting a DTI at a record high of 174%.
This translates to $1.74 of debt for every $1 earned (before taxes).
A high DTI could be a major drawback when you apply for a loan.
A high DTI also spells high risk for banks, lenders, and investors.
It means that the person who has applied for the loan currently has way more debt than income to pay off further debt.
They could always increase the interest rate to cover the risk, however, if the person is already having trouble closing their earlier debt, they might take out a second loan to refinance the earlier loan which is even more troublesome.
In this article, we cover all aspects of the debt-to-income ratio:
- What is the debt-to-income ratio?
- How it is calculated?
- Why is it so important?
- How to manage and reduce your DTI?
What is the debt-to-income ratio?
The debt-to-income ratio is a simple ratio that reflects a person’s total debt against their total income (before taxes).
The DTI of a household is, therefore, the total debt held by all the members of the family, divided by the total earnings of each member, before taxes.
How is it calculated?
This ratio is simple enough to be calculated using your phone’s calculator app.
All you need to do is sum up all your debts (mortgage, credit card debt, car loans, home loans, credit margins, etc.) and divide the sum with your total yearly income (before taxes).
DTI = Total debts / Total yearly income(before taxes)
Here’s a list of all the elements that go into the calculation of total debt.
If you would like to calculate it yourself, you can use this checklist to ensure you don’t leave out any kind of debt.
- Home loan;
- Car loan;
- Appliances and furniture loan;
- Medical bills;
- Credit card bills;
- Credit margins;
- Recreational vehicles (Boats, ATV);
- Student loans;
- Personal loans;
- Other debts.
Similarly, total income should include the following incomes:
- Your monthly income;
- Spouse’s monthly income;
- Alimony received;
- Child support received;
- Retirement benefits.
Here’s an example to help you understand the DTI concept better.
Sam and Karen own a house and a car.
The mortgage balance on their home loan is $150,000, the car loan is $15,000, and $10,000 worth of credit card debt.
Hence, their total debt stands at $175,000.
Both Sam and Karen are jobholders and earn a combined salary of $150,000.
Therefore, to determine their DTI ratio, we will divide their total debt of $175,000 by their total income of $150,000, which gives us a DTI of 116%.
Which translates to $1.16 of debt for every $1 earned.
Why is DTI so important?
The DTI gives you a peek into your financial health.
If your debt is surpassing your income, then that’s not a good sign.
It is normal to have debt as you will need to borrow money sometime or the other to make big-ticket purchases, but you should always ensure to bring the ratio down over time.
For example, if you buy a house, you will take out a loan to fund the purchase which will add a huge chunk to your total debt.
Although this is a necessary expenditure that cannot be avoided, what you can avoid is:
- postponing loan repayments,
- defaulting on loan repayments,
- or refinancing earlier loans.
What you can do instead is bring down the DTI ratio over time by paying the loan EMIs (installments) regularly and trying to increase your income by getting a raise.
The latter is much more difficult to achieve as raises are hard to come by.
Therefore, paying off the debt steadily should be your focus to lower the ratio.
Having a good DTI ratio also makes you more creditworthy.
Lenders see you as a person who pays off their debts in a disciplined manner and is trustworthy.
As such, you get quicker loan approvals and also better interest rates.
People with low credit scores, due to a high DTI ratio, often find it difficult to secure loans.
And even when they do secure a loan they get it against exorbitant interest rates, which is the lender’s way of covering their risk of lending to a person who has high chances of defaulting.
How to manage and reduce your DTI?
To reduce your DTI ratio and bring it to the ideal rate of 36%, you can follow either of the two paths (or both) mentioned below.
- Lower your debt by repaying it
- Increase your income by getting a raise
As mentioned earlier, the latter is a difficult feat to achieve.
So, you should actively focus on reducing your debt because that is something you can control.
Here are some ways in which you can do so:
Pay off your loan before schedule – Opt to pay a bit more than the fixed installment or EMI. If you have more than one loan, then try paying off the one with the highest interest rate first, while making minimum payments to the other loans.
Pay off debt with the highest bill-to-balance ratio – Target the loans that reduce your DTI largely with the least installment paid. These are loans that occupy a large chunk of your total debt. Repaying them will bring down your DTI ratio, substantially.
Negotiate a raise – While paying off debt steadily is a good idea, also try to negotiate a raise at work, so that you can handle your DTI more efficiently. You could also earn some extra money by getting a side job. This will help reduce your DTI ratio.
Transfer your debt – If you get the option of 0% interest credit card, then transfer your debt to it for some time. This will help you pay off your debt with lower installment amounts as the loan will not keep accumulating high interest during that time.
DTI is an easy concept to understand.
Every household should calculate their DTI to find out their current debt situation and how they are handling it.
You can use online DTI calculators to get an idea of the same or like mentioned earlier, calculate it on your home calculator.
Awareness is the first step toward good financial health.
Find out your DTI score right away and then follow the steps mentioned above to bring it to the desired 36% ratio, as soon as you can.