Debt to income ratio

A household can look wealthy on paper and still be one missed bonus away from trouble. The leverage ratio measures how much debt went into acquiring the assets; it says nothing about whether the income arriving each month can actually service that debt.

Debt to income ratio asks the cash flow question instead: of every rupee that comes in, how much is already promised to a lender before anything is spent or saved? It is the parameter lenders themselves use to decide eligibility for an additional loan, which is why an adviser should compute it before the client applies and is refused.

Debt servicing means all payments due to lenders, principal and interest alike. Every EMI, every card payment, every instalment.

A ratio higher than 35% to 40% is seen as excessive. At that level a large part of the household income is committed before regular expenses and savings are met; borrowing in an emergency becomes difficult; and any reduction in income puts the household's finances under stress.

There is no perfect or optimal DTI that lenders require. All lenders agree that lower is better, and each sets its own limit depending on the size and type of loan it is issuing. Like the other personal finance ratios, DTI should be computed periodically — say once a year — and compared with the household's own past numbers to reveal the trend, rather than read once against a textbook benchmark.

Debt to income ratio = Monthly debt servicing commitment ÷ Monthly income

where debt servicing = all payments due to lenders, whether principal or interest.

The workbook gives two cases. An individual earning Rs 1,50,000 a month with loan commitments of Rs 60,000 a month has a DTI of 60,000 ÷ 1,50,000 = 40% — at the edge. A salaried employee drawing Rs 15,000 a month and paying Rs 7,500 towards debt servicing is at 50%, which is too high: half the income is gone before groceries, emergencies or investing.

Now a full household. Mr Menon takes home Rs 1,80,000 a month.

DTI = 97,000 ÷ 1,80,000 = 53.9% — far past the 35–40% mark.

He wants a Rs 25 lakh top-up loan whose EMI would be Rs 23,000. That takes debt servicing to Rs 1,20,000 and DTI to 66.7%. No sensible lender approves it, and an adviser should not want them to.

What actually works is the workbook's own rescheduling rule — rank debt by cost and clear the costliest first. Retiring the personal loan and the card removes Rs 27,000 of monthly outgo:

DTI = 70,000 ÷ 1,80,000 = 38.9%   ← back inside the band

And the stress test nobody runs: if Mr Menon's income falls 20% to Rs 1,44,000, the same Rs 97,000 of EMIs becomes a DTI of 67.4% without his borrowing one more rupee.

Chapter 3 (Cash Flow Management and Budgeting), section 3.9.10, introduces DTI among the personal finance ratios; Chapter 4 (Debt Management and Loans), section 4.2, uses it as the indicator of how much debt a household can take on and as the input to the loan tenor decision. Numeric questions hand you an income and a set of EMIs. Conceptual ones ask which ratio measures the ability of income to service debt — DTI — as against the extent of debt used in acquiring assets, which is the leverage ratio.

• The denominator is income, not surplus. Subtract living expenses first and you have computed a different ratio.
• The numerator is debt servicing — principal plus interest, not interest alone, and it includes every lender, card companies included.
• 35% to 40% is a benchmark, not a rule. The workbook is explicit that there is no perfect or optimal DTI and that each lender sets its own limit by loan size and type.
• Do not confuse it with the leverage ratio. Leverage is a balance-sheet measure of debt used in asset acquisition; DTI is a cash-flow measure of servicing capacity. The exam puts both in the options.
• A DTI inside the band is not proof of safety. Recompute it at a 20% lower income — that is the scenario the household will actually meet.
• Benchmarks are customised. Compare the household with its own numbers from last year before comparing it with a textbook.