What Is a Good Debt to Income Ratio?
A person’s financial health goes beyond their gross monthly income. That’s why it’s a good idea to understand the factors of personal finance, especially the debt to income (DTI) ratio. See what it means, what it’s made of, and how lenders use it when checking borrowers.
Debt to Income Ratio – Overview
Lenders such as banks examine a borrower’s financial health to see if they could approve their credit application or not. This applies to any form of credit, such as personal loans, mortgages, and credit card debts.
Specifically, the assessment looks at the applicant’s income and expenses to determine the person’s debt to income ratio. Also, lenders want to know how the applicant is handling their existing debts, if any.
What’s more, lenders perform these checks to spot any potential issues the applicant may have with repaying their debts. The debt to income ratio helps with this.
A person may lose their means of earning money which could affect their debt repayment. The debt ratio shows lenders how much likely a lender can keep on repaying their debts should this happen.
What Is a Good Debt to Equity Ratio?
The debt to income ratio is also important in assessing a company’s financial health. It even involves factors similar to the ones for individuals.
That’s because businesses also accrue debts as loans or equity. The former mostly includes business loans while the latter refers to support from investors.
Instead of the debt to income ratio, businesses use the debt to equity ratio. It shows whether a company will be able to repay creditors in an event that its profits go down.
You can get the debt to equity ratio by dividing unpaid balances with shareholder equity. It’s best for businesses to have a good level of equity, so it has ample financial fluidity.
In other words, this allows a company to have money ready in case its profits decline. They are likely to keep submitting payments even during a downturn.
A company may also take on more debt or obtain most of its funding from borrowing. This would reflect a higher debt to income ratio. Lenders may see that the company relies too much on debt.
This could mean that they are unlikely to keep up with their debt obligations. As a result, the company may struggle to apply for more loans.
Debt to Income Ratio – What it does
If a company sustains a high debt to equity ratio for too long, it puts itself at greater risk for financial difficulty. The risks just grow as time passes.
As I said, the company may eventually struggle to meet its debt payments. Eventually, it may have to file for bankruptcy. That’s why it’s a good idea to keep a low debt to income ratio.
Companies should curb their borrowing and boost their shareholder equity. That way, they could maintain a healthy financial position. Again, the debt to equity ratio divides its total liabilities with the total amount of equity held.
The debt to equity ratio may also show the amount of money a company owes per dollar of equity it holds. For example, let’s say a company had $60,000 of liabilities and $22,000 of shareholder equity.
It would have a debt-to-equity ratio of 2.73. This means that for every dollar of equity it holds, it owes $2.73 to its creditors. A lower ratio also makes the company more attractive to investors.
What Is Included in Debt to Income Ratio?
Let’s go back to our discussion about people’s financial health and their debt to income ratio. You can compute for yourself this by adding all your monthly debts.
After that, divide it by your total monthly income. Multiply that value by 100 to get your debt to income ratio. This is one of the biggest factors that lenders consider when approving loan applications.
Yet, lenders often base their decisions based on an applicant’s minimum monthly repayments across their outgoing debt payments. Here are the other factors they may consider:
- Recurring mortgage debts
- Credit card payments
- Loan payments
- Childcare payments
- Other financial commitments
Some lenders may also look at any proposed new monthly debt payments. This info may help them estimate whether a borrower can still meet new debt obligations in case their income goes down.
Lenders may also look at other sources of income, not just the usual ones like salary or government benefits. For example, they might check income from part-time or freelance work.
In other words, lenders can choose which debts and earnings they include in the calculations. That’s why they have different ways of computing debt and income ratios.
This is also why applicants must include everything that could help in computing the debt to income ratio. As a result, lenders get a clearer picture of the applicant’s financial position.
What’s more, lenders may have different thresholds and standards when it comes to the debt to income ratio. Still, most lenders reject borrowers who have a debt-to-income ratio of 43%.
Similar to the debt to equity ratio, it’s best to keep it low. As we’ve discussed, lenders prefer a lower debt ratio. Alternatively, a higher ratio of debt and income shows lenders that an applicant may have trouble repaying if their earnings drop.
Debt to Income Ratio – Conclusion
A company’s debt to equity ratio helps investors determine how risky it is to invest in it. Meanwhile, debt to income ratio helps lenders gauge the risk of approving a loan application.
A lower debt to income ratio may show that an applicant will still repay even during financial trouble. On the other hand, a higher figure would show that an applicant is more likely to pay late.
This is why you must reduce your debt ratio before applying for any form of credit. That way, you can see if you’ll be able to repay even during financial difficulty.
Published on February 09, 2019, updated on February 23, 2022.