Debt to Income Ratio

If you’ve never applied for a home loan before, you might not even be familiar with the concept of debt to income ratio.

While ignorance may seem like bliss, this measure of your financial circumstances could be enough to derail your plans of getting into the property market, as it may cause you to be looked on unfavourably as a potential loan candidate.

Read on to find out what debt to income ratio is, and how being aware of it can help.

Debt to Income Ratio

So, what does debt to income ratio mean?

Quite simply, debt to income ratio is a financial measure that compares the amount of debt you currently have to the amount of income you earn. It’s something that’s used by lenders and home loan providers to help them assess whether they feel you’ll be able to reasonably make repayments on a new loan (like a mortgage) you may be applying for.

Greater Bank | Mozo Expert's Choice Home Lender of the Year - 2022

• A low debt to income ratio indicates that you’ve been able to effectively manage the amount of debt you’ve taken on, and have found a good balance. Generally speaking, the lower your debt to income ratio is, the more likely you may be in applying for new loans.
• A high debt to income ratio can indicate that you may have taken on too much debt, relative to the amount of income you currently earn. Having a high ratio can signal to lenders that now may not be the best time for you to take on any more debt.

Calculate Debt to Income Ratio

So, how do you figure out your debt to income ratio? It’s actually pretty quick and painless.

1. Firstly, select a period of time (let’s say a month, for example). Add up all your recurring debt repayments that you currently make in a given month – any credit cards, personal loans, etc.
2. Let’s say the debt you currently service each month is $1,000
3. Then, get a total on your net income (after tax) that you earn in a given month. Let’s say in this instance your income was $3,500.
4. Now, it’s just a case of dividing your debt amount by your income amount - $1,000 divided by $3,500 = 0.285, or 28%. This means that 28% of your monthly income currently goes straight towards making repayments on your existing debt.

Debt to Income Ratio VS Credit Score

When you apply for a home loan, your lender is going to ask for a picture of your current financial circumstances – this will include things like your credit score, your monthly income, and how much you have saved for a deposit and additional costs. But it’s in examining your debt to income ratio that the lender is able to figure out how much you can afford for a home loan.

Generally, it’s a red flag if you have a debt to income ratio that’s too high, with too much of your monthly income going towards servicing existing debts. This is because in applying for a home loan, which is additional debt, the lender needs to be comfortable in their view that you’ll be able to continue to service all your debts on an ongoing basis, at your current income level.

Your debt to income ratio doesn’t affect your credit score. These are completely separate financial measures.

The reason your debt to income ratio doesn’t affect your credit score is that credit agencies aren’t aware how much you earn. They do, however, look at your debt to income ratio on your existing debts – in other words, your total debt amount VS how much you’ve been able to repay.

Lower Debt To Income Ratio

So, knowing that a lower debt to income ratio is looked upon favourably by lenders when it comes to getting a home loan, you might reasonably ask: “How do I lower my debt to income ratio?”

It’s not rocket science, and there’s no silver bullet or easy way out.

Your two options to lower your debt to income ratio are:

Lowering Debt

You may have seen this coming, but one of the key ways to lower your debt to income ratio is by simply reducing the amount of debt you’re currently servicing. In other words – pay down your debts, and do it as quickly and reliably as you can.

Of course, in some cases this may be easier said than done, but it might just be that you need to revisit your budget and see if there are funds that can be freed up to put towards extra repayments on your debt. Do you have a good idea of where every dollar you earn is going? And are there areas of discretionary spending that can be pulled back on, so that you can focus on bringing your debt level down?

Revisiting your budget will cause you to focus more on needs VS wants spending, and may help you to identify some regular small spends that can be cut out to make more money available to repaying your debts.

For example, if we use our example from above, where monthly income is $3,500 and the monthly debt level is $1,000, with a debt to income ratio of around 28%. If you were able to successfully pay down some of your debt and reduce your monthly debt level to $750, this would effectively reduce your debt to income ratio to 21% - quite a drop!

Use our handy budget calculator

Increasing Income

On the flip-side of the equation, another way to effectively lower your debt to income ratio is to increase the amount of income you earn.

Again, not as simple as waving a magic wand, but there are a number of options you could pursue in the search for income growth.

• A second job or some freelance work may be an option. Especially since the pandemic, with more time on their hands, many Australians have been embracing the gig economy and using their current skills to find additional work outside of their main form of employment.
• If there is an option to work more hours, or apply for overtime in your line of work, it could be worth pursuing. If your employer offers overtime, this small sacrifice of time usually spent not working could bring in substantial extra income.
• If it’s not a conversation you’ve had with your employer in a while, you may be able to ask for a pay-rise. With costs of living going up, and many would-be buyers finding it hard to get into the housing market, you may find a sympathetic ear.
• If you’re thinking longer-term, now might be the time for you to complete course-work or additional training outside of work hours that will allow you to successfully apply for higher paying positions down the track.

Apply For A Home Loan At Greater Bank

If you’re thinking of a home loan in the not-too-distant future, as a rule of thumb, most lenders will use a figure of around 28% debt to income ratio as their ceiling for when they’re able to approve home loans.

Of course, there are always exceptions to the rule, but it’s important that you feel that your lender is acting responsibly with their dealings with you, and that’s something we pride ourselves on at Greater Bank.

It's always been our philosophy that our customers should be able to repay their home loans as soon as they can, as it’s the home you want – not the home loan.

If you want to know more about debt to income ratio, or speak to an expert lender about the home buying process, start a conversation with your local lender today by completing a home loan enquiry.

Enquire now