Lenders use various factors to calculate your serviceability before approving your credit application. Serviceability refers to your ability to repay the loan. It is based on multiple factors, including your income, your actual living expenses, and your ongoing debts and other commitments. Many lenders also consider your debt-to-income ratio (DTI) while assessing your suitability for a loan.
DTI is a personal finance measure that helps lenders determine how much of your income is going towards servicing your debts. You can calculate your DTI by dividing your total debts by your overall income. Your total debts will also include the loan you are applying for. Lenders include this figure in your debt calculation to understand how far the new borrowing will push your DTI.
Here’s an example to help you understand how DTI is calculated:
John wants to apply for a home loan worth $500,000. He doesn’t have many ongoing debts, except a car loan worth $10,000. He also has two credit cards with a combined credit limit of $10,000. His annual income is $70,000.
To calculate his DTI, John will add all his debts and divide them by his annual income.
John’s DTI = $520,000 / $70,000 =7.42
How does DTI affect your loan application?
Lenders use your DTI as part of their risk assessment process to determine how much of a risk you pose as a borrower. It helps lenders decide whether to accept your loan application or decline it. In some cases, lenders may use your DTI to calculate the maximum amount of money they might allow you to borrow.
If your debt-to-income ratio is low, lenders believe you have a reasonable amount of money left with you after meeting your monthly loan commitments, and allowing your loan application will not cause you any financial hardship. However, a high DTI can signify too much debt on your hands, and you might struggle to afford your repayments if the lender approves your application.
What is a high debt-to-income ratio when applying for a home loan?
Even though the general formula to calculate DTI is straightforward, different lenders might use slightly different calculations to determine your DTI. Similarly, each lender will have different criteria around the maximum DTI they are willing to accept, depending on their willingness to take on risk. Generally speaking, a DTI of less than six is considered good for most borrowers. Any number over six is considered risky.
If your DTI is more than six, lenders might think you are at a higher risk of defaulting on your loan if the interest rates were to rise steeply or there’s a sudden change in your financial situation. As lenders are required to reasonably ensure you can comfortably pay off your loan, a high DTI over six can lead to your credit application getting rejected, or the lender might reduce the total amount you can borrow from them.
Following John’s example stated earlier, a DTI of 7.42 is relatively high, and John might need to work on reducing his debts or increasing his income to qualify for a home loan, or at least boost his borrowing capacity.
How to reduce your DTI?
Calculating your DTI even before you apply for a home loan or any other form of credit can give you a better sense of your finances. It can help you estimate your borrowing capacity and determine if you have a high level of debt on your hands that could lead to financial stress. If your DTI is more than six, you might find it difficult to qualify for new credit. However, you can take small steps to reduce your debt-to-income ratio gradually and improve your financial situation.
The simplest (though not the easiest) way to reduce your DTI is to increase your income. You may consider a side hustle or work an extra shift to boost your overall income.
Another way to reduce your DTI is by lowering your debt commitments. For example, if you have a good credit score, you might be able to negotiate a lower interest rate on an existing loan. Even though the official cash rate has increased, some lenders continue to offer competitive interest rates to customers. You can compare interest rates online or speak to a mortgage broker to find out if you are on the best deal possible for you, whether it’s a home loan, personal loan, or any other type of loan.
It’s also a good idea to revisit your household budget and cut down on unnecessary expenses to increase your savings and use the spare money to pay off your debts gradually.
