Debt-to-income Ratio | The Basics

Debt is one of those things we hate, but can't seem to live without. We use debt to purchase our cars, homes, fund our studies, and in some cases, pay for food and clothing. These days people are using debt more and more to fund their lifestyles.

The dreaded D-word: Debt

Depending on who you ask, debt has different meanings and elicits different responses. The Oxford Dictionary of English defines debt as "a sum of money that is owed or due." Debt is incurred when an individual receives something (usually cash) now and promises to pay it back at a later date. Paying back the amount borrowed usually involves paying interest as well.

There are several things to consider when looking at debt:

• Interest

• Payment period

• Minimum instalment due

• Debt-to-income ratio before and after taking on debt

Interest

Interest is the expense (or finance charge) for taking on debt. The interest is usually calculated based on the percentage of the loan. The borrower will have to repay the lender what they borrowed. In addition, the borrower will pay the lender more than what they borrowed. This excess is interest (excluding penalties and/or other costs). Interest is paid to compensate the lender for the risk of lending to the borrower. Furthermore, the interest the borrower pays is to compensate the lender for being unable to use the money they lent the borrower.

Payment period

The payment period stipulates how long the borrower has to pay off the amount due. A payment period starts from the time the borrower takes on the debt until they pay it off. Examples of payment periods include six months interest-free accounts and twelve months interest-bearing accounts. 

Minimum instalment due

The minimum instalment due is the minimum amount the borrower has to pay at the agreed-upon payment date. The borrower will have to make this payment at each agreed-upon payment date until the debt is paid off. 

Debt-to-income ratio

A person's debt-to-income ratio is the percentage of their income that goes towards paying for debt. It helps to look at one's debt-to-income ratio before taking on debt because it can help an individual assess whether they can afford to take on the debt. Calculating what one's debt-to-income ratio will look like after they take on the debt can help them see if they'll be overindebted after taking on the additional liability.

We'll take a further look at the debt-to-income ratio and what it means to an individual's finances below.

Debt-to-income Ratio

A debt-to-income ratio is the comparison of an individual's monthly debt payments to their monthly gross income. 

Therefore, it does not come as a surprise that "Households Debt in South Africa increased to 72.80 percent of gross income in 2019 from 71.90 percent in 2018." (Trading Economics). This means that almost three quarters of South African households' gross income goes towards making monthly debt payments. 

How does one calculate what percentage of their gross income goes towards making monthly debt payments? They calculate this by working out their debt-to-income ratio and multiplying it by 100.

Debt-to-income ratio formula

An individual's debt-to-income ratio (DTI %) is calculated as follows:

DTI % = (Your Total Monthly Debt Payments) / (Monthly Gross Income) * 100

It is generally understood that the lower, the better when it comes to one's debt-to-income ratio. This is because consumers with a low debt-to-income ratio are attractive and are perceived as less likely to fail at managing their monthly payments. The consumer in this instance is perceived to be a lower risk than a consumer with a higher debt-to-income ratio (all other things being equal). However, this is not the only factor lenders look at when an individual applies to them for a loan.

 

Let's make use of an illustrative example.

Take Lebo, for instance. Lebo's monthly gross income is R20 000. His monthly debt payments* are as follows:

Based on the information given above, Lebo's debt-to-income ratio can be calculated as follows:

DTI % = (R13 500/R20 000) * 100
            = 0.675 * 100
            = 67.5%

This means that 67.5% of Lebo's monthly gross income goes towards paying his debts. That's just over two-thirds of his monthly gross income. Yikes! 

*Please note that this is only an illustrative example, and as such does not necessarily reflect any individual's actual monthly debt payments and/or monthly gross income. 

So, how does one work out whether or not their debt-to-income ratio is good?

TransUnion (a consumer credit reporting agency) has the following ranges against which it compares your debt-to-income ratio:

• 0 to 20% is considered good

• 21 to 40% is evaluated as fair

• 41 to 60% is seen to be at risk

• 60%+ can be considered over extended

Based on the above, Lebo can be considered over extended (67.5% > 60%). This is because his debt-to-income ratio is within the 60%+ range.

Overextended

An individual is considered to be overextended when they have more debt than they can pay. This can put a strain on a person's finances. Financial strain can have negative mental, physical and social effects. Furthermore, being overextended poses a problem when one is faced with life emergencies such as unexpected medical bills, unemployment, and divorce.

It can be said that Lebo is financially overextended and should consider ways to minimise his debt levels and increase his income in order to improve his debt-to-income ratio.

Closing

This blog post took a look at what to consider when taking on debt and the debt-to-income ratio. Next week, we'll take a further look at Lebo's debt. I hope you enjoyed reading this blog post and learned about debt, particularly the debt-to-income ratio, and the effect this can have on one's finances.

Take care,

Disclaimer:

This blog post is for informational purposes only and does not constitute financial advice. 

The information presented herein is not a substitute for and should never be relied upon for professional financial advice.

Always talk to your financial advisor about the risks and benefits of any financial information shared. If you are looking for financial advice, kindly speak to somebody who is certified and registered with the Financial Sector Conduct Authority (FSCA).

eishstudentbudget™ and its owner(s) are not liable for any loss, harm, or damage you may incur as a result of you using the information presented here.