You have a stable income, pay your credit card bills and loan EMIs on time, and boast a good enough credit score. Still denied a mortgage loan? Wondering what's pulling you back? The answer could be your debt-to-income (DTI) ratio.
Worry not, here in this guide, we explore the importance of your DTI ratio and how it impacts your eligibility for a home mortgage loan. Before we get into the nitty-gritty of the debt-to-income ratio, let's first understand what a mortgage loan is and how it differs from a regular home loan.
What is a home mortgage loan?
In a home mortgage loan, you pledge your property to secure funds. The interest on mortgage loans can range from 8.75% to 13.35%. It depends on the lender and other factors like your credit rating, income levels, and of course, your debt-to-income ratio.
Generally, most banks offer up to 60% of the registered value of the property as a home mortgage. Some banks even offer up to Rs. 10 crores as mortgage loans. Usually, the repayment tenure of mortgage loans ranges up to a maximum of 15 years.
Now, that we’ve seen, what’s a mortgage loan, let’s take a look at how the debt-to-income ratio impacts your ability to avail home mortgage.
How does the debt-to-income ratio impact home mortgage loan eligibility?
In the world of mortgage loans, debt-to-income ratios play a crucial role. Banks measure your distance from the edge using this ratio. Simply put, the debt-to-income ratio is a comparison of your current obligations – credit card bills, and loan EMIs versus your monthly income.
Most borrowers are aware of the importance of the credit score in determining loan eligibility. Just like the credit score, the debt-to-income ratio plays a crucial role in deciding whether you are approved for a home mortgage loan or not.
Two Types of Debt to Income Ratios
Debt-to-income ratios are divided into two types:
The front-end ratio
Also known as housing ratio, it’s the total amount of all your monthly home-related expenses – home loan EMIs, home insurance, homeowners’ association fees, home maintenance charges – divided by your monthly income.
The back-end ratio
The back-end debt to income ratio is all your debt expenses – credit card bills, car loan EMIs, personal loan EMIs, and other debts – divided by your monthly income.
Generally speaking, back-end, debt-to-income ratios are higher than front-end ratios, since the former number includes all your debts, while the latter number indicates only your home-related expenses.
Which ratio do mortgage lenders consider?
Generally, lenders consider the back-end debt-to-income ratios while evaluating your eligibility for a home mortgage. It helps lenders assess the creditworthiness of a borrower.
How to calculate the debt-to-income ratio?
Calculating the DTI is quite simple. Start by finding the total of your recurring monthly debt obligations like – your car loan EMIs, personal loan EMIs, average monthly credit card bills, children's education fees, and more.
Now, divide your gross monthly debt by your gross monthly income. Multiply this number with 100 to get the percentage. The number you arrive is your debt-to-income ratio.
Here’s an example. Let’s consider the case of Mr. A, who earns a gross monthly income of Rs. 80,000. His monthly debt expenses include:
Personal loan EMIs – Rs. 10,000
Car loan EMIs – Rs. 15,000
Average credit card bill – Rs. 20,000
Total debts – Rs. 45,000. Now, dividing this by his gross monthly income = 45,000/80,000 = 0.5625 * 100 = 56.25%
However, note that the debt-to-income ratio doesn't consider your monthly living expenses like food, grocery bills, entertainment expenses, and other miscellaneous expenses. Even if a lender approves your mortgage loan based on your debt-to-income ratio, you need to be extra cautious and consider all your expenses before you take a home mortgage.
Additional Reading: Types of Mortgage Loans
What is a good debt-to-income ratio?
If you have a high debt-to-income ratio, then you may not be sanctioned mortgage or other types of loans. All lenders evaluate the DTI before providing a loan. So, it's essential that you are aware of your DTI ratio before you approach a lender.
Now, coming to the big question – what's a good debt-to-income ratio? A ratio of 36% or less is considered a good one. Unlike credit scores where a larger number is better, in DTI, the smaller the number, the better. Having a low debt-to-income ratio increases the chances of your loan getting approved.
When it comes to home mortgages, the baseline number is 43%. If your debt-to-income ratio is more than this, then your lender will mostly not sanction your loan. If you’re looking for a hard and fast number, then aim for DTI that is lower than 36%.
Smart Ways to Lower your Debt-to-Income Ratio
Your debt-to-income ratio can make or break your chances of securing a home mortgage. If you have a higher number, here are some smart ways to lower it quickly.
Pay off loans ahead of schedule
One of the main reasons why your debt-to-income ratio is high is because you're overloaded with debts. You can overcome this hurdle by paying off your current loans ahead of schedule. If it's not possible to pay off all loans, try to wrap up at least one or two loans to improve your DTI ratio.
Target debts with the highest “bill-to-balance” ratios
Let’s explain this point with an example. Let’s say, you have taken two personal loans. The outstanding on Loan A is Rs. 2,00,000 and you pay Rs. 20,000 as monthly EMI. The outstanding on Loan B is Rs. 1,00,000 and the monthly EMI is Rs. 25,000. Foreclosing loan B first has a greater impact on your debt-to-income ratio as it reduces your monthly debt EMIs significantly.
Try to negotiate a higher pay
Besides lowering your debt, another way to improve your DTI is by increasing your monthly income. If you’re due for a raise in a few months, try to work with your boss to see if you can get your raise immediately. Alternatively, you can try taking on extra responsibilities at work to boost your income.
Earn extra income by taking up a part-time job
Today, there are plenty of side hustles that can be done comfortably over the weekend or by pulling in a few extra hours every week. Taking a part-time job increases your monthly income, which, in turn, reduces the DTI ratio.
Transfer existing loans to other lenders for lower interest rates
Another effective strategy to lower your DTI ratio is by moving your existing loans to another lender who offers you lower interest rates. Reduced interest rates decrease your monthly EMIs, which in turn, reduces your DTI ratio.
Additional Reading: Pre approved mortgage loans
Consider your Debt-to-Income Ratio before Approaching a Lender
Before you approach a lender for a home mortgage, make sure to be aware of your debt-to-income ratio. Use an online calculator to find your DTI ratio. The lower the number, the better are your chances of eligibility and the better are your finances. Make use of the tips listed here to reduce your DTI ratio and increase your eligibility.