The Meaning of Debt-To-Income Ratio and Why It Is Important

Updated: February 27, 2021

In personal finance, your debt-to-income ratio refers to the percentage of your monthly income that goes to your monthly debt payments.

As a financial planner, I typically use a person’s debt-to-income ratio to check their financial standing. Particularly, if they have a healthy cash flow and if it’s okay for them to get a loan.

Knowing your debt-to-income ratio is useful because it can serve as an early warning sign if you’re headed for debt problems.

How to Calculate your Debt-To-Income Ratio

The computation is pretty straightforward. You simply divide your monthly debt payments with your monthly income and then multiply it by 100 to convert the number to a percentage.

Debt-To-Income Ratio (%) = Monthly Debt Payments / Monthly Income x 100

Example:
Let’s say that your take-home pay or net income is P30,000 per month. Then, you’re currently paying P2,000 per month on a personal loan, plus another P1,600 per month on a salary loan. How do you calculate your debt-to-income ratio?

  • Monthly Debt Payments = P2,000 + P1,600 = P3,600
  • Montly Income = P30,000
  • Debt-To-Income Ratio (%) = 3,600 / 30,000 x 100 = 12%

So, your debt-to-income ratio is 12%. But what does this mean? Is this low or high? What’s a good debt-to-income ratio?

Understanding your Debt-To-Income (DTI) Ratio

Along with an individual’s credit history and credit score, their DTI is often used by banks and creditors to check if an applicant can be eligible for a loan.

In general, a person with a DTI of above 40% will be denied in their loan application, or a higher than usual interest rate would be given to them because of the default risk that they carry.

Moreover, in my practice as a financial planner, I use this personal evaluation system:

Less than 20%:
Your debt is manageable and it’s okay to apply for a loan if you’re thinking of getting one.

20% to 30%:
Your debt is manageable, but do not apply for additional loans unless it’s necessary.

30% to 40%:
You’re headed to debt problems if it’s not already happening. Lower your monthly spending and find extra income so you can pay off your debts as early as possible.

Above 40%:
You have a debt problem. Talk to your creditors and know your debt relief options. You may be able to do debt consolidation or ask for a condonation. If possible, seek the help of a financial planner.

Final Words

The best case is of course, to have no debts at all. But as we improve our money management skills and develop good financial discipline, leveraging on debt becomes an efficient strategy to reach our goals.

Lastly, if you’re struggling from debt problems, then listen to this podcast episode where I talked with Mr. Efren Cruz about getting out of debt.

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One comment

  1. I appreciate this article because it is one simple way to determine if a person should even consider taking out any additional loans, adding to their debt load. We certainly can use this calculation in our business working with clients that we assist in getting out of debt. One more way for them to see “the big picture.”

    Still, this article was almost a foreign language to me personally. I have mentioned before growing up in the home of my great depression era Grandparents. Maybe my Grandmother went too far with her frugal ways but never did we have a debt collector pounding on the door! Her simple plan was “we can afford it when we have the cash to pay for it.” Perhaps my Grandparents life is what inspired me to live by the motto, “debt free is the way to be.”

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