Debt to Income ratio is a term that lenders use to determine the serviceability of the loan. This ratio identifies how much of your monthly income is applied towards the payment of ongoing debts such as credit card payments, personal debt, mortgage repayments or car loans. It is your total monthly debts divided by your monthly income.
If your monthly income is $2,000 and you are spending $500 every month towards your repayments, your debt to income ratio is 25%. Lenders do not want this figure to exceed 30-35% of monthly income.
Unfortunately, household debt in Australia is increasing and debt to income ratio is an important figure for lenders to take into account while deciding your loan serviceability. A high debt to income ratio means you are spending too much money to repay debts and there is hardly any disposable income left over from month to month to pay for everyday living expenses.
As a result:
- You may struggle to pay any emergency expenses that arise;
- Banks consider you at a higher risk of default and may not approve your loan at all; and
- Too many rejected home loan or car loan applications will show badly on your credit report.
If you wondered why your money doesn’t seem to go as far as it should, it’s likely that rising debt levels are to blame. In fact, Australian households have the fifth highest debt levels in the world, with more average household debt than comparable economies like Canada.
Average Australian household debt is four times what it was in 1988, rising from $60,000 to $245,000 after inflation. The ratio of household debt to disposable income has almost tripled, from 64% to 185% during the same time.
Declining interest rates, low unemployment and a strong economy have driven Australians to take on more debt and at the same time cushioned the impact of repayments. However, these conditions can be a double-edged sword because interest rates will rise at some point. For households with mortgages and typical levels of debt, a 2.5 percentage point increase would mean debt repayments would rise from 16% to 23% of income, taking annual interest payments from $15,464 to $21,687, or an extra $6,223 per year.
These are mind-boggling figures and should prompt us to scrutinise our own everyday finances, paying particular attention to our debt levels. Ask yourself if you can better manage your finances, including everyday cashflow, as part of a clear, long-term plan to pay down debt. How will you cope if interest rates start creeping back from their current historic lows? What is the contingency plan in the event of job loss or unforseen health event that prevents work?
With Australians – from first home buyers right through to retirees – now in record amounts of debt, managing the debt issue requires prudence in order to impact positively on wealth later in life and provide the sort of retirement we aspire to.
Below are some points to either reduce debt or increase income:
- Make a budget to see where you are spending and where you can cut down.
- Reduce wasteful spending (such as your daily take away coffee and treats).
- Only have one or two credit cards and reduce the limit to what is necessary.
- Identify all of your debts and start paying off the ones with the highest interest rates first.
- Switch to cash to avoid buying beyond your means (a good trick at Christmas time).
- Take up part time work or dabble in your hobbies to make extra money – such as running cooking classes or helping the neighbours with their lawns.
- Rent out a spare room to country university students.
- Be a smart supermarket shopper (there are plenty of tips online).
- Compare utility providers and insurance covers yearly.
- Ask your boss for a raise.
- Refinance your existing home loan to one with a lower interest rate for minimising the interest payments and consequently, adding to your income.
Understanding your debt to income ratio can help you improve your financial condition significantly. Apart from increasing your chances of home loan approval, it will also free up income that you can apply towards other life goals such as building your investment property portfolio.
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Disclaimer: We recommend that you seek independent financial and taxation advice before acting on any information in our articles and newsletters. They contain general information only and have been prepared without taking into account your personal objectives, financial situation or needs. We recommend that you consider whether it is appropriate for your circumstances. Your full financial situation will need to be reviewed prior to acceptance of any offer or product. Interest rates are subject to change without notice. Lenders terms, conditions, fees & charges apply.