Debt to Income Ratios Explained

Managing your money can be difficult when you aren’t sure how much you can afford to pay. If your income is consistent each month but you find you run out of funds quickly, this could indicate you have a large number of outgoings that are both essential and non-essential. If in this situation you want to borrow or consolidate, a creditor may look at your debt to income ratio to help determine a decision. However, if your debt total is larger than your current annual income, this will make it difficult for a creditor to approve your application.

Here at Debt Consolidation Loans, we specialise in helping those with multiple creditors consolidate their debts. Working out your loan to income ratio beforehand will help show your affordability, so here we’ll explain how to calculate yours and what is considered a good ratio.

A young man calls the bank about debt consolidation with Halifax

Why debt consolidation?

  • Improve your monthly budget
    A debt consolidation loan will enable you to group all your existing borrowing and the monthly repayments are easier to manage.
  • Reduced overall repayments
    A debt consolidation loan could even save you money each month if the interest rate is less than the combined total interest of the previous loans.
  • Improved credit rating
    The simplicity of repaying a debt consolidation loan means that you are more likely to repay the debt on time every month. This will prove you to be a responsible borrower, which will have a positive effect on your credit score.

 

What is a Debt to Income Ratio?

A debt to income ratio calculates how many monthly repayments you currently have against your gross monthly income. This is your income before any deductions such as tax, national insurance, your pension etc. This is used by some creditors to determine if you can afford repayments on a new lending agreement. Lending products such as a mortgage or personal loan are a good example of when this may be used. Lenders will all differ on the requirements needed for this and it is usually looked at alongside reviewing your credit history to provide a lending decision. Depending on your loan to income ratio, a lender will decide how much they can lend to you and whether you can afford the required repayments.

How Can I Calculate My Debt to Income Ratio?

To calculate your ratio, you simply take your gross monthly income figure (including any other income from other sources as well as employment) and divide this by your total monthly debt repayments Multiply this total by 100 and you have your ratio %. For example:

  • Total monthly debt repayments – £1250
  • Gross monthly income – £2500
  • £1250 ÷ £2500 x 100 = 50%

To ensure this is as accurate as possible, you should spend time working out all of your monthly repayments to creditors. You should also include any income streams you may have alongside your main employment, so for example, freelance work and any benefits.

Why debt consolidation?

  • Improve your monthly budget
    A debt consolidation loan will enable you to group all your existing borrowing and the monthly repayments are easier to manage.
  • Reduced overall repayments
    A debt consolidation loan could even save you money each month if the interest rate is less than the combined total interest of the previous loans.
  • Improved credit rating
    The simplicity of repaying a debt consolidation loan means that you are more likely to repay the debt on time every month. This will prove you to be a responsible borrower, which will have a positive effect on your credit score.

 

What is a Good Debt to Income Ratio?

Once you have worked the calculation out, what does this mean? Well, the lower the figure you have, the more affordability you should have too. If you have a ratio under 20%, this will inform a creditor you have excellent affordability and will have enough to cover repayments. Anything higher than 40% can indicate you may be struggling to maintain repayments on existing agreements and any further borrowing may cause financial difficulty.

As creditors may use this to determine who they approve for a loan agreement, it’s important to work this out before applying so you can avoid being declined unnecessarily. The good news is there are some creditors or types of borrowing that will not decide a loan only based on whether you have a good debt to income ratio. However, you will still need to determine you have the funds available from an assessment of your finances.

How to Improve Your Loan to Income Ratio

If you have a high ratio, then you’ll want to see if you can improve this as much as possible. If you are planning to apply for any borrowing products, you may want to see what you can do to reduce this first. Some of the best ways to look at reducing your debt to income ratio is by:

  • Reviewing your expenditure and seeing where you can reduce your outgoings. Anything non-essential is where you can reduce spending. You may be able to reduce certain bills such as utility bills to help too.
  • Avoiding applying for more borrowing. If you add more debt to your existing figure without earning more, your ratio will grow.
  • Pay off any debts that have small amounts outstanding. This will help reduce the number of creditors you have and will free up more funds each month.
  • Increase your income. Look at earning more each month either through your regular employment or by looking into ways to supplement your income.

Affording a Debt Consolidation Loan

For those with multiple debts to maintain each month, and their debt to income ratio is high, finding solutions to reduce this issue can seem impossible to find. A suitable option could be to consolidate these debts, helping to reduce the number of creditors needing to be paid. A debt consolidation loan for those with bad credit can turn a difficult situation into an affordable one. As long as you have affordability after reducing your non-essential outgoings, you could then afford to pay the required repayments.

Aiming for a low debt to income ratio is something all borrowers should aim for as it will help make applying for credit in future much easier. However, if you are in a position where your ratio is high and you are looking to reduce this, unsecured debt consolidation loans may still help.

To find out more about debt consolidation loans or working out your ratio, please get in touch.