Why debt-to-income ratio is as important as credit score while taking loans
Posted by: Arti Bhargava on Jul 30, 2018, 06.30 AM IST
Nayan is 32 and engaged. He has shortlisted a house worth Rs 50 lakh and plans to move into it after marriage. He has applied for a home loan and hopes to get it approved as his credit score is a high 824.
Moreover, he has accumulated savings, wihch he plans to use as down payment. He feels he has everything planned well and does not see any issue in getting the loan. However, to his shock, his loan application is rejected.
Why did this happen?
While evaluating the financial fitness of the borrower, banks look at the applicant’s ability to pay off the additional debt burden, besides considering a good credit score. This is where Nayan had a problem, since he has other liabilities like a student loan and an auto loan. The credit score mentions how the earlier loans were serviced, but says nothing about the ability to service more loans.
Debt-to-income ratio (DTI) measures the applicant’s ability to manage debt repayments. It is calculated by dividing the total monthly debt obligations, such as minimum credit card payments, auto loan, student loan and the like, by net monthly income. The ratio is best calculated on a monthly basis. The DTI ratio helps lenders evaluate how much additional debt an applicant’s financial situation will allow him to handle. A low DTI shows you have a good balance between debt and income. Most banks usually use 40% as a threshold limit.
Nayan and his fiancé can still buy the house if she is able to take the loan. Nayan cannot be the co-applicant or even a guarantor. The DTI will come in the way. Better still, he should focus on reducing his overall debt burden by utilising any lump-sum cash inflow towards making such repayments. This would improve his borrowing power and also help him manage his financial situation better, especially during financial emergencies. The lower the DTI, the more appealing a borrower is to the lenders.
The content on this page is courtesy Centre for Investment Education and Learning (CIEL). Contributions by Girija Gadre, Arti Bhargava and Labdhi Mehta