What is Debt-to-income Ratio and how it impacts you
If you want to manage your money responsibly, you probably already know that you should review your finances at least once a month. You might check your bank account for unauthorised charges and make sure your bills are all paid. But you may not have a complete picture of your finances if you aren’t reviewing your Debt-to-income and Loan-to-income ratio along with all of these other factors. Debt-to-income ratio (DTI) tells you what percent of your monthly income goes towards paying your debts. Loan-to-income ratio (LTI) correlates your gross annual wage to your total debt load. If you have applied for a new mortgage or loan recently, you may already know that your DTI & LTI ratio played a role in whether or not you got the loan you wanted. You may also know that a high ratio makes it harder to get a loan.
What you might not know is that a high DTI & LTI ratio could also be a warning sign that your overall credit health—and your credit score—may be heading downhill.
A high DTI ratio, a warning to your credit health
Unlike credit score, which shows how responsible you are at managing debt and paying back your creditors, Debt-to-income ratio tells you how much of your money goes towards repaying your debt relative to the amount of money you make each month.
Monitoring your Debt-to-income ratio could help you see early warning signs that you can’t afford your debt and help you figure out if you need to start cutting back expenses and/or start managing your debt better. That’s why it’s important to keep track of your Debt-to-income ratio, understand how to calculate it, and know how to reduce your Debt-to-income ratio if it’s too high.
Additionally, if a creditor thinks that your Debt-to-income ratio is too high, they may consider you a borrowing risk and decide not to lend to you. On the other hand, you could get approved for a loan or mortgage more easily if you have a lower Debt-to-income ratio. Your creditors may feel that you will be more likely to pay back the loan since your money isn’t already tied up in other debts.
In managing your personal finances, you can calculate your Debt-to-income ratio yourself to make sure that you are maintaining good spending habits and paying down your debt instead of increasing it and leaving yourself less able to save or fund future investments.
How do you calculate your DTI & LTI ratio?
It’s simple to calculate your Debt-to-income ratio on your own, all you need to do is add up all of the monthly debt payments you make to credit cards, personal loans, mortgages, and any other debt. Then, divide that total number by your gross monthly income. Finally, multiply the number by 100 to get the percentage of debt to income.
To calculate your Debt-to-income ratio:
([Total Debt Payments] / [Gross Income]) x 100 = [Debt-to-income ratio]
For example, if you pay $2,500 towards your debts every month and your monthly income before taxes is $6,000, your debt-to-income ratio would be 41.6%.
To calculate your Loan-to-income ratio:
([Total Loan Balance] / [Gross Income]) = [Loan-to-income ratio]
For example, you have a $300,000 mortgage, and a $10,000 credit card, you earn $72,000 gross pa, divide $310,000 by $72,000, your Loan-to-income score will be 4.3x.
What DTI & LTI ratio should you aim to have?
As a general guide, a Debt-to-income ratio should not be higher than 40%, ideally under 25%. In terms of Loan-to-income ratio, various banks have their own LTI ceiling levels (as they do with DTI), according to Morgan Stanley research, the industry DTI average is 4.9x, so try to maintain your level below this ratio.
If your Debt-to-income ratio is above 40%: you will most likely have trouble being approved for a new line of credit because creditors may consider you a high credit risk who will won’t be able to pay for any additional debt.
How to improve your DTI ratio
Unless you are making a major purchase that adds to your debt amount, your goal should always be to lower your Debt-to-income ratio so that you can focus on saving for the future. The less dependent you are on debt, the more energy you can put into building wealth and preparing for financial emergencies by saving your extra money in an emergency fund.
The best way to fix excessive debt or high DTI is, paradoxically, increase your DTI ratio as much as you can! That is to say, dedicate as much of your surplus financial resources to pay your debts down. Minimise your expenses, maximise your opportunities for income and pay as much of the difference towards your debts as you can.
Before long, your debts have reduced and so has your DTI ratio.
Your Debt-to-income & Loan-to-income ratio is a good measuring stick for your financial health, the ratios will help your bank gauge your creditworthiness when you apply for a mortgage to finance your dream home.
It’s always best to keep to this rule of thumb, keep your unsecured debts to a minimum, or non-existent, and save your money.
If you have a client struggling with debt, we may be able to help, contact us on 1300 490 030 or [email protected]
This article should not be considered legal advice, but as a general guide only. If you are facing legal recovery action, please consult a legal attorney to assist you. For further information on how to have your debts cut by half or more through a specialist negotiator, reach out to us on [email protected] or contact us on 1300 490 030.