11 Apr The Role of Debt-to-Income Ratio in Loan Approval
Your debt-to-income ratio is how much your total monthly debt repayments are compared to your gross monthly salary and income (income before taxes and deductions). It’s used by creditors, particularly mortgage creditors, to determine how risky of a lending candidate you are: how well you manage your current monthly repayments and whether you can afford to take on more.
You can work out your DTI ratio by dividing the total amount you pay in monthly debt repayments by your gross monthly income, then multiplying that by 100. For example, let’s say you make R25,000 a month and your total monthly repayments are R8,000. If you divide 25,000 by 8,000 and multiply the result by 100, you’ll find that your DTI is 32%. Good DTIs are usually considered anything below 36%, however, one that’s in the range of 36% to 43% is generally acceptable to lenders. Anything above 43% is generally risky to lenders, and a DTI above 50% is usually too high for approval.
Debt-to-income ratios are crucial to lenders when assessing your eligibility for a credit facility. A high DTI (debt-to-income ratio) tells lenders that you’re likely to default (not pay them back) or miss payments, which they naturally would like to avoid. If you are approved, you’ll likely be granted less credit than you asked for or suffer higher interest rates. Lenders charge higher interest rates as a sort of insurance policy – if you default, at least they’ll have recovered more of their money than not.
Why else are debt-to-income ratios important to lenders? This post explores why DTIs are important to lenders and how you can improve your debt-to-income ratio.
Why Are Debt-to-Income Ratios Important to Creditors?
DTIs are important to creditors because it’s often a legal or regulatory requirement that debtors have a certain DTI, it’s a risk indicator, and it tells them how much money they should lend you or the amount they should charge in interest.
It’s Often a Legal or Regulatory Requirement
When lenders assess whether they should grant you credit, they conduct an affordability assessment, which is mandated by the National Credit Act. If your DTI is above a certain range, it’s an indication that you’re likely to default or miss a payment. If they lend you money anyway, they’re a perpetrator of reckless lending, which is illegal.
It Indicates Risk
Debt-to-income ratios demonstrate how high a risk you are. If you have a high amount of debt compared to what you earn monthly, it would be a bad idea to lend you more money than you can afford. Using a lot of credit illustrates that you’re credit-reliant and struggle to manage your finances – a warning sign to lenders.
It Tells Them How Much They Should Lend You or How Much They Should Charge in Interest
If your DTI is above a certain threshold, you may only qualify for a lower amount than you initially requested. Creditors also use your DTI to decipher how much they should charge you in interest. As mentioned above, interest rates are a sort of insurance policy that helps them recover more of their money than they otherwise would have.
How to Reduce Your Debt-to-Income Ratio
You can reduce your DTI by clearing the amount of debt you owe. The less debt you have, the lower your debt-to-income ratio will be, helping you qualify for more loans with better terms. Credit Boost can assist you with lowering your DTI by providing helpful guidance on how to reduce your debt. To learn more, contact us today.