Debt-to-income ratio explained: The key factor behind personal loan eligibility

Debt-to-income ratio, i.e., DTI, has emerged as one of the most important metrics that borrowers in the country rely on while conducting a background check on personal loan applicants and their applications.

Banking institutions and NBFCs are mandated to closely monitor bad loans. This makes borrowing for weak-credit-holding individuals difficult. That is why, to make the process of personal loan and credit card approval smooth, one should not only have a respectable credit score but also a low debt-to-income ratio.

Why DTI matters more today

The DTI ratio measures how much of a borrower’s monthly income goes towards existing debt repayments. Most lenders in the country prefer a DTI of 30–40%, though some may allow up to 50% for high-income applicants. A lower ratio signals better repayment capacity and, therefore, lower credit risk.

Basic concept of DTI

The basic concept of the debt-to-income ratio is that it measures how much of a borrower’s monthly income goes towards meeting existing debt obligations. For example, if your monthly income is ₹1,00,000 and out of this ₹25,000 goes towards clearing out your monthly personal loan EMIs, home loan EMIs and credit card bills, etc. Then you have a debt-to-income ratio of 25%.

Furthermore, a debt-to-income ratio of 30-35% is generally considered a respectable figure. Most lenders permit loan disbursements with a debt-to-income ratio of 30-35%. Now, when the debt-to-income ratio rises further, i.e., it goes past 50% the borrower's credit profile becomes weak. Such a high debt-to-income ratio is seen as a serious red flag by the lender and depicts a clear possibility of defaulting on borrowed funds.

A lower debt-to-income ratio signals better repayment capacity. Thus, signals a lower credit default risk. The focus of borrowers should therefore be to bring down the overall debt-to-income ratio to lower double digits if possible. This will add immense credibility to their borrowing profile.

Key reasons lenders prioritise DTI

1. Risk assessment: This ratio assists in determining whether a borrower can manage additional EMI obligations without financial stress or not.
2. Loan pricing: A lower DTI can lead to more competitive interest rates and flexible tenures.
3. Deciding eligibility: Applicants with a high DTI often face personal loan rejections, despite having a strong credit score.

How DTI impacts loan approval

Lending institutions check various factors such as credit scores, DTI, employment history, income stability, and past repayment history to holistically analyse one’s creditworthiness. Now, out of all these factors, DTI is given immense significance as it provides a clear view of the cash flow health of an aspiring borrower.

If you already have very high debt repayments, this will discourage lending institutions from considering you for an easy personal loan, home loan, or credit card. A healthy debt-to-income ratio might also help you with lower processing charges, easier approval and seamless support from the lending institution.

How borrowers can improve their DTI

• Clear out high-interest debts or consolidate personal loans.
• Ensure that you avoid unnecessary EMIs before submitting any new loan application.
• Try to increase your monthly income through freelance work, incentives or rental yields to boost this ratio.
• Never borrow for meeting leisurely expenses, such as expensive watches and clothes.

Prudent borrowers should diligently focus on the DTI ratio to significantly enhance their credit profiles and maintain high credit scores. A credit score of 750 or higher is considered reputable, and this score, along with a low debt-to-income ratio and a clean credit profile, can significantly influence the eventual interest rate on a borrower's personal loan.

For all personal finance updates, visit here.

Disclaimer: Mint has a tie-up with fintechs for providing credit; you will need to share your information if you apply. These tie-ups do not influence our editorial content. This article only intends to educate and spread awareness about credit needs like loans, credit cards, and credit scores. Mint does not promote or encourage taking credit, as it comes with risks such as high interest rates and hidden charges. We advise investors to discuss with certified experts before taking any credit.