September 26, 2015

Last week, you read that a Debt to Income ratio (DTI) is a personal finance measure that compares the amount of debt you have to your overall income.

In debt management counseling services, we think that being at or less than 30 percent is safe, between 35 and 40 percent is preferable and above 40 percent is dangerous.

A low debt-to-income ratio (below 30%) demonstrates a good balance between debt and income because borrowers with a lower debt-to-income ratio are more likely to successfully manage monthly debt payments.

What is not a good DTI ratio?

A high debt-to-income ratio ( above 40%) signals that you may have too much debt for the amount of income you have, and this can be viewed as a sign that you would be unable to take on any additional debt. In most cases, 43% is the highest ratio a borrower can target.

When the DTI ratio is high, your ability to make repayments is poor and the chances of you defaulting (not making repayments) are higher. If you borrow further with a high DTI, you risk having your hire purchase goods or even your house repossessed by the bank or credit provider.

The following example shows what a bad DTI ratio is:

Mamta is married with two children. She is employed as a senior clerk. Mamta decided to apply for a personal unsecured loan of $2000 from her bank for a trip to Australia. She already has an existing personal unsecured loan with her bank for which $267 is deducted from her fortnightly pay. She is also paying $60 per fortnight for a smartphone and another $70 for a flat screen TV she bought during Christmas. Her total debt repayment every month comes to $794. Her total monthly net salary is $1080. So her DTI is ($794 ÷ $1080) x 100 = 73.52%. This is well above the recommended 30% to 40% considered to be within the safe zone.

Mamta is hoping that her loans officer will approve her loan. Currently, for every dollar she earns per month, about 74 cents is used to repay her existing debts. Her husband, who has a similar salary level, is in a same situation as most of his salary is going towards repaying their home loan. If her loan is approved, her repayments will increase significantly and the family will be left with even lesser cash for their daily expenses.

If my DTI ratio is above the recommend range, what should I do?

You should simply avoid taking further loans. First clear your current debts if you wish to borrow more. You can also use your hobby to make some money to ease your financial situation.

What if my loans officer says it is okay to borrow with my high DTI ratio?

Be careful about loans officers who may try to convince you to take out loans. The banks/credit providers also need to be responsible when giving out loans. As a golden rule, they must give proper consideration to your DTI ratio and ability to repay your loans.

Remember, it is YOU and not the loans officer or the bank that will be doing the repayments!

The bank’s calculation of my DTI ratio is lower than my own calculation. What should I do then?

It is important that you analyse your own DTI ratio before engaging in any borrowing. Remember, you are the one who will be paying off the loan. You know your financial situation better than anyone else. The bank or credit provider really doesn’t know your spending habits such as the frequency of eating out or going to the movies, etc. No matter what information/documents you provide to the bank or credit provider to assess your loan application, he/she never really is able to get the complete picture of your financial situation.

Next week, read on what options are available to you if you are unable to make your monthly repayments because you have lost your job or fallen ill.