What Is a Debt-To-Income Ratio and How Does It Affect Your Personal Loan Approval Chances?

What Is a Debt-To-Income Ratio?

If you’re familiar with business media, you may already have come across the concept of debt-to-income (DTI) ratios. Simply put, the debt-to-income ratio calculates the personal debt that a borrower has outstanding versus the monthly income they generate.

This ratio is usually expressed as a percentage. You can either use a debt-to-income ratio calculator or calculate it manually on your own. For example, picture a borrower with $1,000 of monthly credit card debt, $200 of student loan payments, $300 of car loan payments, and $5,000 of monthly salaried income. The ratio would be calculated as ($1,500/ $5,000) x 100% = 30%.

At its core, the debt-to-income ratio calculates how much you owe to lenders for every dollar you earn. The ratio is used for a variety of purposes. Most commonly, lenders will use it to evaluate your capacity to take on another loan such as a mortgage or auto loan. However, the Bank of Canada also tracks the average national debt-to-income ratio of all Canadians to set monetary policy. A high ratio indicates households are increasingly more leveraged.

In Q1 of 2021, the Canadian household debt-to-income ratio was 182.5%. In other words, the average Canadian household owed $1.83 of debt for every dollar that they earned.

Understanding Your Debt-To-Income Ratio

Depending on the size and type of your loan, lenders may have different ways to calculate your debt-to-income ratio. When you apply for a new credit account such as a personal loan or mortgage, the lender will calculate this ratio to understand the percentage of your current income that goes into paying off debts. The lender will then assess this debt-to-income ratio before making a final decision on approval.

Typically, a ratio of 35-36% is considered to be acceptable. Depending on the type of lender you go with though, you may be able to obtain a loan with up to 45% debt-to-income.

The higher your DTI ratio, the riskier the borrower you are considered to be. All else equal, a person with 40% DTI represents more of a credit risk than someone with 35% DTI. This is because 40 cents of every dollar that the former earns goes towards debt repayments. On the other hand, the latter only spends 35 cents of every dollar earned on debt repayments. This means that the person with 35% DTI has some more room to take on additional debt while the person with 40% DTI would likely struggle under incremental debt.

Improving Your Approval Chances

Given that the DTI ratio represents a major consideration for lenders when evaluating loan applications, it is prudent to try and improve your ratio prior to approaching a lender for additional credit. Some of the ways that you can do this are as follows:

1. Increase your rate of monthly debt repayments If your financial situation allows you to increase your rate of monthly repayments, you should strongly consider this option. As you pay down higher amounts, you will pay less in interest payments over time while gradually also reducing your debt. As your debt declines, your DTI ratio inches lower.

2. Avoid adding more debt to your finances Before you approach your lender for additional credit, try to avoid incurring any other credit or debt. Any incremental debt you incur will reflect negatively on your DTI ratio and may prevent you from being able to qualify for the loan.

3. Increase your down payment When obtaining new debt, try and increase the amount that you put down towards the purchase. With a higher down payment, you have to borrow a lower amount of principal for the loan. Ultimately, this reduces your DTI ratio.

4. Develop a financial plan for repayment Discipline is your best friend when it comes to progressively reducing debt over time. By developing a sound financial plan and sticking to a set budget for your day-to-day expenses, you can set aside adequate amounts each month to repay debt. In a month where you are able to save a larger amount, use the excess cash to pay down your debt quicker than planned.

5. Explore new income streams While paying down your debt is paramount to achieving a good DTI ratio, the other lever you can pull is an increase in your total income. While this is of course easier said than done, there are certain options you can explore. You can search for a new job, ask for a promotion or raise, or even offer freelancing services on sites such as Upwork or Taskrabbit.

Final Thoughts

Understanding and optimizing your DTI ratio can go a long way in setting you up for success when obtaining a new loan. If you are facing a high DTI ratio, try following the steps above to bring your ratio down before you approach a lender.

However, you may need a loan on a short timeline. Magical Credit has worked with thousands of borrowers with challenging financial profiles to offer competitive, cost-effective personal loans. Reach out to our team today to learn more!