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What is a healthy debt-to-income ratio?
Access to credit depends on how much of your income already goes to debt payments.
Almost everyone is feeling the pinch of high inflation, and you might be considering applying for more personal credit to help with your cash flow. However, whether you apply for an overdraft, a personal loan or a credit card, your bank will need to make sure that you can afford the new credit product before you can be approved. To judge affordability, your bank will first check your credit report (a record of how well you’ve managed debt in the past) and your credit score.
Credit scores are determined by credit bureaus, and your score depends on both your credit report and how much debt you are currently paying off. If you’ve made mistakes handling debt in the past and you have a poor credit score, you’re unlikely to be approved. It’s best to check your credit score on the Nedbank Money app, take control of your debt and develop new habits to improve your credit score before you apply for any more credit.
Assuming you’ve maintained a healthy credit score, however, your bank will judge your affordability based on your total income, minus your regular monthly expenses (such as rent, groceries, utilities, etc) and your monthly debt payments (including vehicle finance, home loans, personal loans, revolving credit facilities, etc). The percentage of your income devoted to debt payments is called your debt-to-income (DTI) ratio.
How to work out your debt-to-income ratio
First, determine your gross monthly income. This is your income before tax and must include all your sources of income, including any side hustles. Then, add up all your monthly debt payments, including home loan, car finance, insurance premiums, outstanding credit card balances, personal loan, and so on. Divide your debt by your income and multiply the number by 100, and that percentage is your DTI ratio. You can also use our debt-to-income calculator.
The lower it is, the better. It’s clear that a DTI ratio of 100% means that you’re spending all your income paying off debt, which is an unhealthy financial situation to be in.
A healthy DTI ratio is a good sign that you’ll be able to meet any further debt obligations. However, the specific percentage that is considered a healthy DTI ratio will vary depending on your individual circumstances. A common benchmark to aim for is a DTI ratio below 36%.
Let’s illustrate with some concrete examples:
Say you earn a gross monthly income of R20,000, and you have existing debt payments totalling R4,000 a month. Your DTI ratio is 20%. If you apply for a personal loan with a monthly repayment of R2,000, your total monthly debt payments will increase to R6,000 a month, and your DTI will rise to 30%, which is still a healthy balance between debt and income.
Maintaining a healthy DTI ratio is vital, to ensure financial security and avoid undue stress
On the other hand, say you earn a gross monthly income of R25,000, with monthly debt payments of R5,000. Your DTI ratio is still only 20%, but you apply for an overdraft facility with a maximum limit of R10,000. You can use all the credit available in your overdraft, but you must also pay it back in full every month. If you were to do that, your total monthly debt payments would increase to R15,000, which is a DTI ratio of 60%. This indicates a heavy reliance on debt and may raise concerns about your financial stability.
Striking the perfect debt-to-income balance
Here are a few tips to manage your monthly debt payments so that you can maintain a healthy DTI ratio:
Budget wisely
Create a comprehensive budget to manage your expenses and ensure that your debt obligations remain within manageable limits. Nedbank makes it easy to budget with the Money app and My Smart Money.
Prioritise saving
As soon as you start earning an income, open a savings account to cover unforeseen emergencies. When you have an amount equal to 3 to 6 times your monthly income safely stashed in your emergency fund, you can investigate other savings and investment accounts. These will allow you to put money aside for specific life goals, so you don’t have to rely on credit to afford them.
Limit borrowing
Avoid taking on excessive debt. Borrow only what you can comfortably afford to repay.
Look for the best rates
The interest rate is the most important factor determining how much a specific debt will cost you overall. When you’re applying for credit, compare offers to find lower-interest loans and credit options. These will help you keep monthly payments within manageable limits.
Pay off excess debt
Focus on repaying existing debt to improve your DTI ratio and overall financial health. A consolidation loan could help you clear problematic debt in one go, leaving you with only one loan payment to make every month. Depending on the interest rate, you may end up paying less every month than you were before.
Maintaining a healthy DTI ratio is vital, to ensure financial security and avoid undue stress. Debt can be a useful way to achieve your aspirations, but only if you borrow responsibly. If you’re thinking of applying for any new credit, consult a Nedbank financial adviser. They can help you make sure that taking on new debt aligns with your financial goals and doesn’t jeopardise your long-term financial well-being.
