In personal finance segment, apart from investing, proper debt management also helps in achieving your long term financial goals. In the present situation, where availing debt has become easier, given if you have a good credit score and ability to service it, efficient management of debt is also necessary.
Efficient debt management doesn’t only helps to improve credit score, but also helps to keep your finances in shape and keeps you ready for the next challenge. In an event of a debt trap, where you are unable to service it or major part of your income goes after its repayment, the situation becomes very difficult at both ends.
So, how to know your debt levels are within comfortable limits and how to avoid falling into a debt trap?
One of the key metrics for finding out your debt repayment capability or appetite to avail new loans is knowing your Debt-to-Income ratio. Banks rely heavily on this ratio more than the credit score to find out your creditworthiness.
Debt to Income Ratio
The debt-to-income ratio shows the borrower’s capability to service the debt compared to his/her gross monthly income. It is calculated by dividing all monthly payments towards debt by gross monthly income.
Having a lower debt-to-income ratio increases the chances of loan application getting approved by the bank quickly. If you check, most of the loan application with higher credit score failed to get approved because of the high debt-to-income ratio of the borrower.
How Much Debt-to-Income Ratio is Good
Having a lower debt-to-income ratio is always preferred to keep your financial health in the right shape. Below are the different slabs.
Less than 36%
Its an excellent category, where you can easily manage your debt against your gross monthly income. Banks also prefer to approve the loan, if you fall under this category.
36% – 49%
This falls under the medium category, and if the debt is not properly managed at this stage, it can have a negative effect on your overall financial health. The first to-do is to improve your debt-to-income ratio and aim for the first slab.
More than 50%
Its a red zone for you, as more than 50 per cent of your income is going towards servicing the debt. In this case, you have very less room to save and repay back the loan earlier. Chances of a debt trap are higher at this stage.
How to Improve Debt-to-Income Ratio
- Allocating more funds to high-interest debt and prioritize it as it will help to lower overall debt and improve debt-to-income ratio in a very short period of time.
- If possible, refinance your existing high-interest paying debt to low-interest debt to bring down the overall interest cost and increase principal repayment.
- Avoid taking any new loans and keep your expenses under check to avoid slippages.
To sum up, Debt-to-income is not only useful for the banks but also comes handy, when managing your debt portfolio. Its give a better idea, on how to manage your finances in a better way and plan accordingly.