Check Your Debt to Income Ratio Before Applying for a Loan

By Angela Monroe - March 18, 2020

There are lots of things you’ll want to consider before you apply for a loan. Lots of people know about loan terms and the importance of figuring out which interest rates work best for them, but fewer people know about the debt to income ratio.

Knowing as much of the terminology around loans as possible is really helpful when it comes to researching the right loan for you. The debt to income ratio is something that often gets forgotten but it’s really important to understand so you can make an informed decision when applying for a loan.

Understanding the debt to income ratio

This is a term that is used by lenders to figure out the serviceability of a loan. You can calculate the debt to income ratio by calculating the total of all your monthly debts, and dividing it by your monthly income.

Monthly debts can include everything from credit card and mortgage repayment repayments to car loans.

For someone who has a monthly income of $2500 and spends $500 each month making repayments on debts, the debt to income ratio would be 20%.

For a lender to approve a loan, they will generally require the debt to income ratio to be below 30% of a person’s monthly income.

High debt to income ratio

If you calculate your debt to income ratio and it is very high, it may mean that you are spending too much money per month to commit to repaying your debts. Lenders will see this as a red flag, particularly if they are concerned about whether you have any disposable income left over at the end of each month in case of an emergency.

A high debt to income ratio means that you are likely to be considered as a high-risk borrower by a lender as they see you as more likely to default on loan repayments. This may result in your loan application not being approved.

Being rejected for loans due to a high debt to income ratio can actually be the start of a vicious cycle as multiple rejections for loans on your credit history will also ring alarm bells for potential lenders – even if you do get your debt to income ratio to decrease.

How to improve your debt to income ratio           

The best approach to take when trying to improve your debt to income ratio is to reduce your debt whilst also increasing your income. You may be surprised at how quickly small steps can help to make a big difference so set this as a high priority if you’re looking to get a loan in the near future.

Reducing your debt:

There are lots of ways you can reduce your debt but here are some of the top steps to success:

  • Make a list of all your current debts (be as honest as possible) and figure out which ones are costing you the most in monthly repayments. Prioritise these and start to pay them off first.
  • Live within your means and only spend what you can afford. Some people find it easier to do this by only using cash or a debit card to avoid the temptation of spending on credit cards.
  • Cut down on luxury items such as take out coffees or gym membership. You’ll be amazed at how much you can save by daily changes to your spending habits.
  • Reduce the maximum limit on your credit cards if you do still want to use them to avoid spending beyond what you can afford.

Increasing your income:

  • Try and take up some extra shifts or part-time work to make a bit of extra money each week to add to your monthly earnings.
  • If you have a spare room in your house, consider having a lodger to help pay your mortgage.
  • Research alternative suppliers for your utility bills or insurance and see if you can reduce your monthly repayments
  • Consider refinancing your current home loan to see if you can reduce your interest rates and paying less in total each month.

Timing your loan application

If you have a very high debt to ratio income, the chances are that you may be rejected by a lender rather than approved for the loan that you want. A high debt to ratio income can contribute to a bad credit rating, which often raises red flags with lenders who see you as high risk to lend to.

You should seriously consider whether you can delay the timing of your loan application until you have improved your debt to ratio income. With the steps above you may see changes happen fairly quickly so if you’re able to wait just a few months until you’re in a better financial state, you could see your chances of loan approval improve.

If you don’t have time and you need to take a loan as soon as possible, you’ll want to find the right lender who specialises in working with people with bad credit. Working with lenders who are experienced helping people with bad credit means that you’ll get the right help and advice for you.

Angela Monroe
Angela Monroe is the Community Manager at The Positive Group, specialising in giving people the information that they need when they need it, and putting you on the path to a fair financial future. She has 8 years of experience in helping Australians find the right finance solutions, and regularly contributes articles to empower Australians with the knowledge they need to become financially healthy.

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