Debt ratio, also known as debt-to-income ratio, is one of the most important factors when it comes to assessing your financial situation. This is how banks measure your ability to make repayments, whether you plan to open a credit card, take out a loan, or even apply for a mortgage.
The more you understand your debt ratio, the better equipped you’ll be to use it to your advantage. However, there’s a lot of confusion around what this term means and how it works in practice.
While you might be familiar with things like credit rating, this term represents its own part of your financial story. In this guide, we’ll dive deep into what debt-to-income ratio is and why it’s important.
What Is Debt Ratio?
To begin, let’s define debt ratio. Also known as debt-to-income ratio (DTI) or loan-to-income ratio (LTI), this is a way for banks to understand how much debt you have in relation to your income.
As a calculation, debt-to-income ratio is your total debts divided by your income (before tax). It’s a way to look at your full list of debts and liabilities in relation to how much you earn. If banks were to just examine how much debt each individual has, this wouldn’t be a fair assessment. Because everyone has a different level of income, debt-to-income ratio takes the full picture into consideration to determine creditworthiness.
It plays a strong role in your credit rating. Ideally, you want to keep your DTI low. This means you should try to have as little debt as possible compared to your income.
Let’s try an example to see how the ratio works in action. Say you’re a married couple, and you make $160,000 total ($80,000 each). If you have a mortgage for $300,000 and a credit card with a monthly limit of $5,000, your total debt is currently $305,000. We take this number and divide it by your income, arriving at a DTI of 1.9. In other words, your total debt would be 1.9 times your combined income as a married couple.
How Do Banks Use It?
Your debt-to-income ratio is important because it’s how banks determine whether you’re able to reasonably pay back your loan or line of credit on time. Each bank has its own standards and criteria for eligibility, and these are based on the debt-to-income ratio.
Most banks have limits set for DTI. This is usually set between 7 and 9. That means your debt-to-income ratio can’t be above 7 since this would be a risky loan in the eyes of the bank.
While there are loans and lending options available for those who don’t have a strong debt-to-income ratio, it’s likely that you won’t be a good fit for traditional loan options.
What to Do If Your Debt Ratio Is High
Having a debt ratio that’s too high is considered to be at high risk of financial stress. What does that mean? While it’s different for everyone, it is a sign that you could face problems if your financial situation was to change suddenly. If any of the following happened, you might not be able to make ends meet:
- Sudden job loss
- Family emergency
- Medical costs
- Rise in interest rates
- Change in family situation
If you’re worried about your ratio, it’s time to create a strong debt payoff strategy. The best way to improve it is simple: pay down your debt. Of course, this is easier said than done. However, with the right debt solution and a functional budget, you can improve your debt-to-income ratio in a matter of months.
Once your debt-to-income ratio is within healthy limits (typically considered to be under 6), you’ll have greater eligibility for different lending options. That being said, it’s important to avoid taking any additional debt that you don’t need.
Your ratio is only one side of the story. Many lenders will also consider your living expenses, additional income, and types of debt. Ultimately, banks want to know they’re lending to people who they determine are creditworthy. Ensuring you have a good credit rating and debt ratio is the best way to do just that.
Final Thoughts
If you’re considering taking on a new loan, mortgage, or debt solution, your debt ratio is important. While it doesn’t tell the full story of your financial situation, it’s one of the many things banks look at closely. As a borrower, you can prepare for your loan application by reducing any unused debt to lower your overall debt-to-income ratio.
Even if you’re worried about your current situation, you have options. At Debt Busters, we have over 15 years of experience helping Aussies manage their credit and debt to create a long-term strategy forward. Whether you’re hoping to improve your debt ratio or avoid more debt, contact a member of our expert team on 1300 368 322 to get started. We’re here to help!