debt to income ratio
debt to income ratio

A Beginner’s Guide to Understanding Debt-to-Income Ratio

For many Filipinos, navigating financial concepts and terms can feel like venturing into uncharted territory. Among these, the “debt-to-income ratio” (DTI) stands out as a crucial metric, yet it often leaves many puzzled about its importance.

This article aims to demystify what DTI is, why it matters, and how it influences your financial well-being. We’ll guide you through understanding the importance of a good DTI, identifying factors that affect it, and learning how to calculate your own ratio. Whether you’re planning for a loan or striving for financial stability, understanding your DTI is a step to making informed decisions about your finances.

What is the Debt-to-Income Ratio?

The debt-to-income ratio compares your monthly debt to your total monthly income. It shows how much of your income goes toward your debt payments. Knowing your DTI helps you manage your finances better by offering a clearer picture of your debt repayment, enabling you to make informed decisions about spending and saving.

What Is the DTI Ratio Used For?

When loaning for a new home, car, or credit card, lenders look into two key factors: your credit score and your debt-to-income ratio. Your DTI is a big deal for lenders because it helps them figure out if lending you more money is a safe bet.

A good DTI ratio suggests you can effectively manage your debts relative to your income. This boosts your chances for loan approvals and better loan conditions. On the other hand, a high DTI might raise suspicion, signaling you might be juggling more debt than you can comfortably handle.

In essence, maintaining a healthy DTI ratio not only demonstrates your financial responsibility but also opens the door to more favorable loan opportunities, making it a crucial aspect of your financial toolkit.

credit score shown in a laptop

Credit Score vs. Debt-to-Income Ratio

Understanding the interplay between your credit score and your DTI ratio is key, especially for loan concerns like “Does credit score affect mortgage?” While both credit scores and DTI ratios are critical in the lending process, they serve different purposes.

Your credit score reflects your credit history and repayment behavior, impacting loan eligibility and interest rates. In contrast, DTI calculates your debt burden relative to your income, influencing how much you can borrow. A high DTI might limit your loan options even with a good credit score, as it suggests a higher risk of repayment difficulties.

Ultimately, while the DTI ratio is a crucial consideration for lenders evaluating credit applications, it represents just one of several metrics. This underscores the importance of managing both your DTI ratio and credit score to enhance your eligibility for credit.

debt

Debt-to-Limit Ratio vs. Debt-to-Income Ratio

Often, DTI ratios get mixed up with debt-to-limit ratios, but these are distinct from each other. The debt-to-limit ratio, also known as your credit utilization ratio, looks at how much of your available credit you’re actually using. Think of it like this: lenders are checking to see if you’re filling up your credit cards to the limit.

In contrast, the DTI ratio focuses on comparing your monthly debt payments to your overall income. It’s all about understanding how much of your income goes towards debt, while credit utilization zeroes in on how you manage the credit limits on your cards.

income versus debt in a scale

How to Calculate Your Debt-to-Income Ratio

So, how do you compute your DTI ratio?

1. List All Monthly Debts. Start by adding up all your monthly debt payments. This includes any mortgages, car loans, student loans, and minimum payments on credit cards. Exclude your monthly bills like phone or internet since you can adjust or cancel these services without repaying a debt.

2. Determine Your Gross Monthly Income. This is the total money you earn each month before taxes or any other deductions.

3. Use the DTI Formula. Divide your total monthly debts by your gross monthly income. The result is your DTI ratio. 

Formula: DTI = (Total Monthly Debts / Gross Monthly Income) x 100.

Example: Suppose you have monthly debts of PHP20,000 (PHP10,000 for your mortgage, PHP5,000 for car loan, and PHP5,000 on credit cards) and a gross monthly income of PHP60,000. Your DTI ratio would be (20,000 / 60,000) x 100 = 33.33%. This means 33.33% of your monthly income goes towards debt repayment.

What Is a Good DTI Ratio?

A general rule of thumb in the Philippines is to aim for a DTI of 30% or lower, especially for home loans. This ratio assures banks that you’re standing on stable financial ground, making you a safer bet for lending.

However, what’s considered “good” can change depending on the lender or the type of loan you’re eyeing. A lower debt-to-income ratio is always better. It means you’re using less of your income to pay off debts, which signals to lenders that you’re less of a risk. This also means that, although learning how to save money is important, having debts does not necessarily signal financial trouble especially if you have a healthy DTI.

Tips for Maintaining a Good Debt-to-Income Ratio

Here are some practical ways to manage and improve your DTI:

calculating monthly debt

Reduce Monthly Debt

Lowering your total recurring monthly debt can significantly improve your DTI ratio. In addition, focus on allocating part of your budget to pay off debts to improve your DTI over time.

Increase Gross Income

Boosting your income without increasing debt also lowers your DTI ratio. Consider a second job or freelance work to supplement your primary income.

budget tracker

Create a Budget Tracker

Monitor your spending using a simple sheet on Google Sheets or Excel. This will help you identify areas where you can cut costs and allow you to redirect funds toward reducing debt, eventually improving your DTI ratio.

Decrease Monthly Expenses

Examine your monthly expenses to find areas where you can scale back. Simple changes, such as eating out less or canceling unused subscriptions, free up more money to reduce your debts.

avoiding taking on new debts

Avoid Taking on New Debts

While it might be tempting to take on new credit, prioritizing the repayment of existing debts over acquiring new ones is crucial for lowering your DTI ratio and maintaining financial stability.

Remember, different lenders may consider various types of income and debt in their DTI calculations. Engage with your lender to understand their specific criteria and enhance your chances of loan approval by aligning with their standards.

Master Your Debt-to-Income Ratio

Calculating your debt-to-income ratio isn’t just about numbers; it’s about gaining control over your finances. Understanding what DTI is helps you manage your debts more effectively and also plays a crucial role in maintaining a good credit score.

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