Buying a home is one of the biggest financial commitments that one undertakes. It usually needs a huge corpus, which is met through both a significant down payment and a loan. Due to the large amount and long repayment period, home loans are sanctioned after scrutinising multiple factors to gauge the financial history and repayment capability of the applicant. CIBIL score is one of these factors which is an indicator of one's creditworthiness and the discipline of the candidate in repaying prior debt.
Another essential factor that is considered at the time of determining one's home loan eligibility is the debt-to-income ratio. Continue reading to learn more about what the debt-to-income ratio is, how is it calculated and its impact on housing loan eligibility.
What is a Debt-to-Income Ratio?
Debt-to-income ratio is a metric used to evaluate one’s housing loan application, similar to one’s CIBIL score. It is the share of one’s income that has to be used to make debt payments in the form of EMIs of various secured and unsecured loans and credit card payments.
While the CIBIL score indicates one’s credit repayment history, the debt-to-income ratio measures the ability to make future repayments of loans.
A housing loan is a long-term commitment; therefore, an indicator such as the debt-to-income ratio shows the lenders that one is not overusing debt already to meet their financial requirements. In case one is, then they might not be a suitable candidate to obtain more debt and repay it in a timely manner.
How to Calculate Debt-to-Income Ratio?
The debt-to-income ratio formula consists of the sum of all monthly debt payments and total monthly income from all active and passive sources.
It is calculated by dividing your total monthly debt payments by your gross monthly income.
Monthly debt payments could be EMIs of any loans that you might have taken such as personal loans, car loans, education loans and your monthly credit card payments.
Active income is the income you earn from your occupation in the form of a salary, commissions, tips, fees, etc. Passive income is the income that you earn using your assets such as rental income, interest income, dividends, capital gains, etc.
Here is an example of how to calculate debt-to-income ratio:
Suppose your car loan EMI is Rs. 10000
Personal loan EMI is Rs. 8000
Monthly average credit card bills are Rs. 10000
Your total debt will be: Rs. 10000 + Rs. 8000 + Rs. 10000 = Rs. 28000
And
Salary is Rs. 75000
The average monthly income from interest on FD and dividend payments is Rs. 5000
Your total income will be Rs. 75000 + Rs. 5000 = Rs. 80000
Hence your debt-to-income ratio will be the total debt divided by the total income = 28000/80000 = 0.35 or 35%
What is a Good Debt-to-Income Ratio?
A debt-to-income ratio of 35% or lower is usually considered safe by lenders. This ratio implies that even after payment of your current monthly liabilities, you still have enough income left to handle a home loan installment comfortably. One would be a favorable candidate for lenders if their debt-to-income ratio falls below this number.
If the debt-to-income ratio lies between 36% and 49%, then you would not be the most favorable candidate for lenders, but you would still be seen as someone who can improve their financial health to manage a home loan. However, you must attempt to reduce this ratio to below 35% for having maximum chances of getting a home loan approved.
A debt-to-income ratio of above 50% makes you a risky borrower for the lenders. Your home loan application will most likely be rejected unless you make some serious attempt to lower this ratio.
How to Reduce Your Debt-to-Income Ratio?
Here are some of the steps you can take to lower your debt-to-income ratio if you are planning to apply for a home loan:
#1. Increasing EMI and paying off debts: Try to increase your EMI and pay off as much debt as you can in the short term. This will reduce your overall outstanding debt, and hence reduce the debt-to-income ratio.
#2. Restructuring loans to reduce EMIs: If it is not possible to make lump sum payments to reduce your debt or there are prepayment penalties, you can try and get your loan restructured to lower your EMI. This will reduce the debt-to-income ratio as it is calculated based on monthly debt repayments.
#3. Cut down on credit card expenses: Do not buy very expensive items using credit cards to bring down your overall credit card payments.
#4. Avoid credit card debt: If you are used to paying the minimum amount due on credit card bills, start paying the full amount and settle the credit card dues.
All of these steps will help to quickly reduce your debt-to-income ratio to become better eligible for a home loan
Summary
To summarise, the eligibility for a housing loan not only depends on the credit score which shows how disciplined one has been in managing their previous credit, but also on their ability to pay off a new loan in the future. The debt-to-income ratio is a metric that measures the latter. It clearly shows the percentage of the income already being committed to meeting existing debts. Therefore, it is important to use a debt-to-income ratio calculator and ensure that you lie in a comfortable range before applying for a housing loan. Tata Capital home loan eligibility calculator automatically calculates your home loan eligibility using simple inputs such as monthly income and obligations. If needed, take the necessary steps to significantly reduce your debt to increase your chances of obtaining a home loan.
14 June 2023
5 mins read
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