How to calculate the Borrower Debt Ratio
Understanding the borrower debt ratio is crucial for individuals and businesses seeking loans. Lenders use this metric to assess a borrower’s ability to repay debts based on their income and existing financial obligations. A high debt ratio can indicate financial strain, making it harder to secure loans, while a low debt ratio suggests financial stability.
The borrower debt ratio, commonly referred to as the debt-to-income (DTI) ratio, measures the percentage of a borrower’s gross income that goes toward servicing debts. It is a key determinant in loan approvals, influencing how much credit financial institutions are willing to extend.
Lenders consider two main types of debt ratios:
- The Front-End Ratio – Also known as the housing ratio, this calculation focuses on housing costs, including rent or mortgage payments, property taxes, homeowners’ insurance, and other related expenses.
- The Back-End Ratio – This is a more comprehensive measure, taking into account all debt obligations, including housing costs, car loans, credit card payments, student loans, and any other outstanding debts.
Both ratios are essential in determining whether a borrower can comfortably afford additional financial obligations.
Calculating the Borrower Debt Ratio
To calculate the debt-to-income ratio, the borrower must follow these steps:
First, add up all monthly debt payments. This includes rent or mortgage payments, car loans, student loans, credit card minimum payments, and any other recurring debt obligations.
Next, determine the borrower’s gross monthly income. This is the total income earned before taxes and deductions, including wages, business earnings, rental income, and any other consistent sources of income.
Once these figures are available, the debt ratio can be calculated using the following formula:
Debt-to-Income Ratio (%) = (Total Monthly Debt Payments ÷ Gross Monthly Income) × 100
For example, if a borrower has total monthly debt payments of Sh50,000 and earns a gross monthly income of Sh200,000, the DTI ratio would be:
(50,000 ÷ 200,000) × 100 = 25%
A DTI ratio of 25% indicates that 25% of the borrower’s gross income goes toward paying debts.
Interpreting the Debt Ratio
Lenders use the debt ratio to assess a borrower’s financial risk. A lower ratio is generally preferable, as it suggests that the borrower has enough income to cover debts and other living expenses.
Most lenders consider a DTI ratio of 36% or lower as a healthy benchmark for borrowing. A ratio above 43% is often viewed as risky and may limit the borrower’s chances of securing a loan.
For mortgage approvals, financial institutions typically require a front-end ratio of 28% or less and a back-end ratio of 36% or less. However, some lenders offer flexibility, especially when the borrower has a strong credit history or significant assets.
If a borrower’s DTI ratio is too high, they may need to take steps to improve their financial standing before applying for a loan. Some effective strategies include increasing income through additional employment or business opportunities, reducing debt by making extra payments on existing loans, and avoiding unnecessary borrowing.
Managing expenses wisely and maintaining a good credit score can also enhance loan approval chances. Borrowers who anticipate financial strain should consider debt consolidation or restructuring options to ease repayment burdens.
Author: Andrew Walyaula
Andrew Walyaula is a seasoned multimedia journalist. waliaulaandrew0@gmail.com
