Debt-to-income ratio: what does it mean?

If you are considering a home loan or personal loan, or want to get a better sense of your finances, it may be helpful to work out your debt-to-income ratio. This can help you estimate if you have too much debt without having to wait until you realise you can’t afford repayments, or your credit score starts slipping. Plus, it’s relatively easy to calculate.

In our current environment with interest rates stabilising, those with a high DTI will need to pay particular attention, as they may face more stringent borrowing capacity constraints as a result.

What is a debt-to-income ratio?

A debt-to-income ratio compares the amount of debt you have to your overall income. Lenders, including issuers of mortgages and other financial institutions, use your debt-to-income ratio as a way to measure your eligibility for credit based on your perceived ability to manage repayments.

To calculate your debt-to-income ratio, you need to add up your total credit or debt balances and divide it by your total gross annual income (your salary or total annualised income each year before tax and other deductions are taken out).

As a hypothetical example, say you are in a couple and have a home loan of $400,000, a personal loan of $14,000 and a credit card of $4,000. You and your partner earn $80,000 each, annually.

This takes your total liabilities to $418,000, and your total gross income to $160,000.

Your debt-to-income ratio would therefore be 2.61 ($418,000 divided by $160,000).

What debt and credit facilities are considered in your debt-to-income ratio?

The debt and credit that financial institutions may look at when calculating your debt-to-income ratio include:

• Credit card debt (amount owed)
• Micro-financing or instalment plans, such as Afterpay or Zip Pay
• Personal loans
• Car loans or asset finance
• HECS/HELP loans
• Home loans
• Investment loans, lines of credit and/or margin loans

As a general guideline, if information doesn’t show on your credit report, it’s not factored into your debt-to-income ratio by lenders. Your credit report contains details about your credit history, with the information used to calculate your credit score. Also known as a credit rating, your credit score is a number that’s calculated by a credit bureau to suggest how trustworthy you are as a borrower.

→ Check your credit score for free with Canstar

How do lenders use your debt-to-income ratio?

While there are variations between the different types of debt-to-income ratios that lenders will accept when assessing prospective borrowers, banks and financial institutions generally apply the debt-to-income ratio as part of the credit analysis process.

This process determines the amount of credit risk a borrower has which the lender can use to decide whether to accept or decline their loan request and to pinpoint the amount they will allow the customer to borrow. If a customer has a low debt-to-income ratio, this means that a bank will be more likely to accept their request as they have the income and ability to successfully make the repayment.

Some lenders, particularly non-banks, have their own ways to measure whether a customer will be able to make repayments, such as the Net Service Ratio which assesses serviceability. To calculate the Net Service Ratio, lenders take into account a prospective borrower’s after-tax income, and then subtract expenses and other liabilities to work out the loan amount the customer may be able to repay.

How do the big four banks use your debt-to-income ratio?

When it comes to the big four banks, each financial institution offers and accepts different debt-to-income ratios depending on their unique processes. See below for a breakdown, as at the time of writing:

• ANZ won’t accept applications where the debt-to-income ratio is greater than 9 for any home loans
• CommBank’s credit department needs to manually approve applications with a debt-to-income ratio higher than 7
• National Australia Bank has a debt-to-income ratio cap of 9 for all home loan applications
• Westpac has a policy for debt-to-income ratios of 7 or greater, whereby your application will be referred to its credit department for further review.

How does a high or low debt-to-income ratio impact consumers?

A high debt-to-income ratio directly affects a consumer’s ability to secure a loan. A debt-to-income ratio of around 6 is generally considered high. Different institutions have different rules around what they consider, but if you have a debt-to-income ratio of 9 or above you likely won’t be considered for a loan with the major institutions.

A low debt-to-income ratio is generally under 3.6, and is often viewed favourably by lenders. Having a low debt-to-income ratio can help show an ability to successfully manage debt. Consumers with a low debt-to-income ratio may be more likely to be offered lower fees and rates by prospective lenders and may also have more loan options to choose from.

→ Related article: Interest rate ranges: How is your rate determined?

What can you do if you have a high debt-to-income ratio?

If you have a high debt-to-income ratio, there are some things you could do to improve it, including reducing your monthly debt payments or increasing your income. Some suggestions include:

Reducing your debts by:

• Working to increase your credit score, which may enable you to negotiate a lower rate on existing loans
• Making a budget to limit your spending
• Minimising unnecessary expenditure
• Using debt reduction strategies (e.g. consider if a mortgage offset may be helpful for you if you have a mortgage, in addition to making extra home or personal loan repayments)
• Looking at options to refinance your home loan to lower your interest rate.

Increasing your income by:

• Considering a side hustle or income-producing investments.

In conclusion, keeping your debt-to-income ratio low can help you ensure you can afford your debt repayments and give you the peace of mind that comes from handling your finances responsibly. It can also help you be more likely to qualify for credit for the things you really want in the future.

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