Debt to Income Ratio (DTI) & its Effect on Home Loan Approval

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Nowadays everyone wants to have their own home or wants to start a business or anything big. Everything requires money and that too in a lot of sum. 

 

But every time you have this much money in your pocket is not possible. To make it possible you need a loan or debt for your requirements. And maintaining this debt while continuing your income to grow can be tricky and hard to handle on your own. 

 

So Debt to Income Ratio comes to your rescue. But how?

 

Let’s translate it into simple words.

 

When you’re applying for loan credit assessors or loan lenders look at various factors to determine how much you can borrow and whether they will approve your loan application or not. These factors include:


  • Loan-Value-Ratio

  • Servicing capacity

  • Credit history and conduct

  • Debt-to-Income Ratio


When you apply for a home loan or personal loan, lenders see your debt-to-income ratio to know how reliable you are and how good your debt balance is with respect to your income. Debt to Income ratio also helps you in determining whether your debt is going out of control or not. 


For good financial health, maintaining a moderate level of debt is critical. 


So, if you’re thinking about taking out a loan or just want to get a better handle on your finances, figuring out your debt-to-income ratio can help. 


This ratio assists you in determining if you have too much debt, or your credit score begins to deteriorate. 


Don’t worry if you didn’t understand what DTI is and how it works. Keep on reading to know much more about it.


What is a Debt-to-Income (DTI) Ratio?


A debt-to-income ratio (DTI) is a personal finance metric that compares your total debt to your total income. Lenders, such as mortgage lenders and financial institutions, use your debt-to-income ratio to assess your creditworthiness based on your estimated capacity to make repayments of loans.


Debt (D) considers the home loan you’re seeking, as well as any previous debt, such as HECS (Higher Education Contribution Scheme), HELP (Higher Education Loan Program), total car loan owed (not just the monthly repayment in the borrowing capacity), and overall credit card limit.


Income (I) is your gross earned revenue over the whole year (your salary or total annualised income each year before tax and other deductions are taken out). It includes all forms of income such as rental income, bonuses, and commissions.


To figure out your debt-to-income ratio, add up all of your credit or debt balances and divide by your entire annual gross income 


For example, if you are a couple and you have taken a home loan of $500,000, a personal loan of $15,000 and a credit card of $5,000. You and your partner both earn $80,000 each, annually.


This makes your total liabilities $520,000 and your total gross income $160,000.


Your debt-to-income ratio would be 3.25 ($520,000 divided by $160,000). It means you owe 3.25 times what you earn.


To put it simple DTI refers to the total debt you have divided by the gross income you earn per year.


DTI is another important technique that a lender uses to ensure you don’t get into too much debt at any point in time. They try to ensure that you do not spend more than 30-40% of your income on loan repayments by limiting your entire debt situation. This means you should always be able to comfortably fulfil your loan instalments and avoid financial difficulty.


What debt and credit facilities are considered in DTI calculation?


While determining your debt-to-income ratio, financial institutions consider the following debts and credit recorded on your credit report.


  • Credit card debt (amount owed)

  • Micro-financing or instalment plans (buy now pay later facility).

  • Personal loans

  • Car loans or asset finance

  • HECS/HELP loans

  • Home loans

  • Investment loans, lines of credit and/or margin loans


Lenders do not consider the information that does not appear on your credit report when calculating your debt-to-income ratio. Your credit report includes information about your credit history, which is used to determine your credit score. 


Your credit score, also known as a credit rating, is a number produced by a credit agency or credit bureau to indicate how trustworthy you are as a borrower.


How Do Lenders Use Your Debt-to-Income Ratio?


Well, there are different ways lenders use and determine the DTI ratio. Generally, DTI ratios are used as a part of the credit analysis process by banks and financial institutions.


DTI helps in assessing a borrower’s credit risk, which the lender can use to determine whether to approve or deny their loan request. As well as what is the maximum amount that any borrower can borrow. When a customer’s debt-to-income ratio is low, a bank is more likely to approve their request because they have the income and ability to make the payments.


Some lenders, especially non-banks, have their methods for determining if a borrower is able enough to make payments. Like Net Service Ratio which evaluates serviceability. 


Lenders calculate the Net Service Ratio by subtracting costs and other liabilities from the borrower’s after-tax income to determine the loan amount the customer may be able to repay.


Some are more strict than others, while some may be more lenient or employ a higher DTI. When you apply for a loan, our brokers can assist you in determining which lender is the greatest fit for your circumstances.


A higher assessment rate is another strategy used by lenders to lower the debt-to-income ratio. This implies they will apply a bonus interest rate to whatever interest rate you have been provided on the loan to ensure you can cover loan repayments if interest rates rise. This also has the effect of restricting your total borrowing capacity.


Lenders changed their systems during COVID-19 to properly examine how the epidemic affected a customer’s income or employment. Many were requesting bank statements from customers, particularly those who were self-employed, to confirm that their current business turnover, costs, and net income were comparable to or better than their pre-COVID-19 turnover. This way lenders were able to assess the borrower’s ability to repay the loan.


How does a high or low DTI ratio impact consumers?


A high debt-to-income ratio has a direct impact on a consumer’s ability to obtain credit. The average debt-to-income ratio is approximately 6. Various institutions have different guidelines about what they assess, but if your debt-to-income ratio is 9 or above, you’re unlikely to be considered for a loan from one of the main lenders.


A low debt-to-income ratio (DTI) of less than 3.6 indicates that you have a limited amount of credit. A low debt-to-income ratio indicates that you can successfully manage your debt. Hence you are often seen favourably by lenders. Consumers with a low debt-to-income ratio are more likely to receive reduced prices and rates from prospective lenders, as well as more lending possibilities.


Most Australian lenders now use the DTI to determine how much they will lend you. The acceptable DTI for many lenders is now between 6 and 7. This means that some banks will lend up to seven times your gross income, while others will only lend up to six times. 


What can you do if you have a high debt-to-income ratio?


There are several things you can do to improve your debt-to-income ratio if it’s too high, such as lowering your monthly debt payments or raising your income. Following are some ideas that can help you:


Reduce your debts by:


  • Make a budget to keep your spending in check.

  • Reduce unnecessary spending.

  • Use debt management techniques.

  • Consider refinancing your earlier mortgage to lower your interest rate.


Increase your income by:


  • Consider starting a side business.

  • Start putting money in income-producing investments.


Conclusion


Keeping your debt-to-income ratio low will help you to ensure that you can manage your debt repayments easily. And provide you with the peace of mind that comes with properly managing your money. It then also become easier for you to get credit for the things you actually want in the future.


It became more crucial than ever to speak with a broker about your lending situation. We live in an increasingly complex world where you must consider not only the lender and the interest rate, but also the assessment rates, acceptable DTI ratios, and servicing conditions of each lender.


All this information seems to be very confusing and doing it on your own might put you in trouble. So instead of going all by yourself, ask your mortgage broker or talk with us to get help. Our brokers will help you in determining which lender is the greatest fit for your circumstances and what loan you should take that you can easily repay.


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