When planning to apply for a personal loan, auto loan, or mortgage, the first thing to consider is your income. Are you making enough money, or do you have disposable income that will ensure you make the minimum repayments and avoid default? One way to test this is to know your debt-to-income ratio (DTI.)
Lenders will often look at your DTI ratio when building a credit risk profile and evaluating your creditworthiness. Lenders use this metric to gauge your ability to service a loan. Typically, the lower your DTI ratio, the more likely you are to be approved for a loan — granted, you also meet other minimum requirements.
Therefore, if you are considering applying for a loan, you first need to know your DTI and how to improve it if it doesn’t meet a lender’s threshold.
This article will explore what the debt-to-income ratio is, how to calculate it, and everything in between.
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Your debt-to-income ratio (DTI) is your total monthly debt payments divided by your total gross monthly income, multiplied by 100 and expressed as a percentage. The value you get represents the amount of your income that goes to debt repayment each month. For instance, if you make Ksh75,000 and spend Ksh25,000 servicing loans, your DTI is 33.3%.
Ideally, a percentage of your income should cover your living expense, savings, and, if you have any debts, the monthly repayment. But if you spend a significant percentage servicing debts, this might signal to lenders that you are not a reliable borrower.
When your DTI is higher than the lender's requirement, you might be denied a loan, or if you are approved, the terms might be less friendly as you have a bad risk profile. This is why you must always strive to maintain a good DTI ratio.
DTI is a simple calculation that compares your monthly debt payments to your monthly income. To calculate your DTI ratio, follow these three easy steps.
Step 1: Start by adding up your monthly gross income, which includes all of your reliable sources of income, such as your day job and side hustles. However, don't include any income that is inconsistent or unreliable. For example, if your day job pays Ksh70,000 monthly and your side hustles bring in an additional Ksh15,000 monthly, your gross income would be Ksh85,000.
Step 2: Next, add up all of your monthly debt repayments. This could include student loans, personal loans, auto loans, and mortgages. If you pay Ksh5,000 per month for your student loans and Ksh30,000 per month for your auto loan, your total monthly debt repayment would be Ksh35,000.
Step 3: Divide your monthly debt payments by your monthly gross income. Using the above example, your DTI ratio would be Ksh35,000 divided by Ksh85,000, which equals 0.41 or 41% when expressed as a percentage.
DTI = Monthly Debt Payments ÷ Gross Monthly Income
Debt-to-income ratios typically only consider your monthly debt payments and gross income and do not include living expenses such as groceries, car insurance, or entertainment expenses. However, while these expenses are not factored into the calculation of your DTI ratio, it's still important to budget for them and considers them when making financial decisions.
Ideally, you should keep your DTI below 36% as it indicates that you have a manageable level of debt in relation to your income. The lower your DTI, the better your chances of securing credit or loans at favourable terms, and the more financially stable you appear to lenders.
It's important to note that different types of loans have different DTI requirements. For instance, a mortgage loan usually requires a lower DTI ratio than a personal or business loan. So, knowing the specific DTI requirements for that loan type is essential if you plan to take out a loan.
Keeping your DTI low should always be a priority, as lenders ultimately determine whether your DTI is suitable for your risk profile. A high DTI ratio can negatively impact your credit score, making it difficult to get approved for future loans.
Here are five reasons why DTI is essential in financial decision-making:
Lenders use DTI to measure how healthy your cash flow is before offering you a loan. If you are already spending much of your income repaying other loans, that might signify to them that you might have a problem servicing a new debt. A low DTI ratio indicates a healthy balance between debt and income, which might increase your chances of getting your loan approved.
So how do lenders know you have other debts?
They will usually pull your credit report from a CRB. The report will usually show if you have other existing debts. But this report will only contain formal debts from financial institutions like banks, Saccos, and microfinances.
As a responsible borrower, you should factor in other debts you might be servicing when calculating your DTI. This includes debts from friends, family, or even shylocks.
It is also important to know that lenders will consider your DTI for secured and unsecured debts. Just because you have collateral doesn’t mean your DTI isn’t factored in.
Finally, a higher DTI doesn’t typically mean you will be denied a loan. A lender might ask you to demonstrate how you plan to repay the loan, and if you have a solid plan, your loan might be approved. But since the lender will be taking a risk on you, the terms might be less friendly. For this reason, it is recommended that you lower your DTI before you apply for a loan.
Improving your DTI involves lowering your DTI to be below a lender's requirement. After doing research and you find that your preferred lender has a DTI requirement of less than 35%, there are some steps you can take to reduce your DTI to that threshold if it is higher.
Some of those steps include:
Maintaining a low debt-to-income ratio is essential in demonstrating your financial health to lenders. However, it's not the only factor that lenders consider. As a borrower, you must take steps to make smart borrowing decisions.
The first step is to work on your overall creditworthiness and consider other metrics, such as credit score and payment history. Additionally, shopping around and comparing different lenders based on their DTI requirements can help you find a loan that fits your needs. Finally, consider seeking guidance from a financial expert to help you make an informed decision.