Personal Loan: How does your DTI ratio affect your chances of getting a loan?

When you apply for a personal loan, the bank or NBFC considers various factors for loan approval. Some of these include your age, monthly income, credit score, profession, debt-to-income (DTI) ratio, etc. The DTI ratio is an important factor for deciding on loan eligibility, amount, etc. So, what is the DTI ratio, how to calculate it, how much should it be, why do banks consider it for personal loans, and how to improve it? Let us discuss.

What is the debt-to-income ratio and how to calculate it?

The debt-to-income or DTI ratio is the percentage of monthly income an individual uses towards servicing debt obligations. These include loan EMIs, credit card outstanding, etc. For example, an individual's monthly income is Rs. 1,00,000, and Rs. 20,000 is spent on servicing debt obligations. In this case, the individual's DTI ratio is 20%.

Now that we understand what the DTI ratio is, let us understand how to calculate it. The formula to calculate the DTI ratio is as follows.

(Total monthly debt repayment / Total monthly income) X 100

For example, Dimple’s monthly income is Rs. 1,50,000 and monthly debt repayment is Rs. 25,000. Dimple’s DTI ratio will be calculated as follows.

= (25,000 / 1,50,000) X 100

= (1 / 6) X 100

= 0.1667 X 100

= 16.67%

So, Dimple’s DTI ratio is 16.67%. The next question that comes to mind is whether the above DTI ratio is good or bad, what is an ideal DTI ratio, and how does it affect an individual’s chances of getting a personal loan?

What should be an individual’s DTI ratio?

Every bank or NBFC can decide for itself what is a good DTI ratio. Usually, most banks and NBFCs consider a DTI ratio of 35% or less as good for giving personal loans and other loans. However, it is important to note that apart from the DTI ratio, other factors like monthly income, credit score, age, profession, etc., also play a crucial role in deciding whether the personal loan should be approved or not.

The lower the DTI ratio than 35%, the better your chances of getting a personal loan. If the DTI exceeds 35%, the bank will scrutinise your personal loan application and documents more closely. Some banks may consider a DTI ratio of up to 40 – 45% range and still approve the personal loan application. For personal loan applications with a DTI ratio above 45%, the approval chances go down significantly.

How does the DTI ratio impact your chances of getting a personal loan?

A DTI ratio of 35% indicates that only 35% of your overall income is going towards servicing debt. It means your leverage is less, and you are managing debt well. It indicates a good balance between income and debt.

After considering a DTI ratio of 35% and regular living expenses taking another 30 to 35% of your monthly income, you will still be left with free cash flows of 30 to 35%. As this amount can be used for servicing any additional debt taken, the bank may approve your personal loan application. A lower DTI signals the bank that you (the borrower) have the financial flexibility to accommodate more debt and service it comfortably.

As the DTI ratio goes above 35%, after considering the regular living expenses, the capacity to service additional debt goes down. At a DTI ratio of 45%, after considering the regular living expenses, there is limited capacity left to service additional debt. Hence, most banks will not approve an additional personal loan for an individual with a DTI ratio higher than the 45 to 50% range.

A higher DTI indicates a person has taken too much debt for the monthly income that they are earning. A higher DTI ratio is a red flag for the bank as it reduces the borrower’s scope to accommodate more debt and service it comfortably. The higher the DTI, the riskier banks will consider the borrower profile and their personal loan application.

A higher DTI ratio impacts your personal loan application in the following ways:

1. If the DTI ratio is above a specified percentage, the bank may reject the personal loan application.
2. If the DTI ratio is higher than the bank’s comfort level of 35%, the bank will check the personal loan amount applied for. The bank may reduce the personal loan amount applied for and make a counter offer to the applicant with a lower loan amount.
3. If the DTI ratio is higher, the bank may ask for additional documents or collateral/guarantor and then reconsider the loan application.
4. The bank may ask you to work on improving/lowering your DTI ratio and re-apply for the personal loan after a few months.

How to improve your DTI ratio to increase your chances of getting a personal loan?

Now we understand what a good DTI ratio is. If your DTI ratio is higher than required, and if you want to apply for a personal loan, you should work towards improving/lowering your DTI ratio. You can lower your DTI ratio by making additional payments over and above your regular EMIs.

If you have multiple loans outstanding, instead of making additional payments, you can foreclose one or multiple loans over the next few months by paying the entire outstanding amount for those loans. Another option is to restructure your existing loans to increase the tenure and lower the EMIs. These measures will help you lower your DTIs.

If you have planned any big-ticket purchase, check if it can be postponed for a few months. The amount available can be used for clearing existing loans and reducing the DTI ratio. Once the DTI ratio reaches a comfortable level, you can make a personal loan application with the bank or NBFC.

Check your DTI ratio before applying for a personal loan

Now you understand what is the DTI ratio, how it impacts your personal loan application, and how to improve it. The next time you want to apply for a personal loan, check your DTI ratio, credit score and other factors that play an important role in personal loan approval. Many websites/apps have online DTI ratio calculators. You need to input your monthly income, amount towards servicing debt, and other data (if any). If your DTI ratio is on the higher side, work towards reducing it before applying for a personal loan.

Gopal Gidwani is a freelance personal finance content writer with 15+ years of experience. He can be reached at LinkedIn.