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A red signal that tells you to stop borrowing
Sheetal Jhaveri
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May 23, 2008

Recently, I received a frantic mail desperate for help from Mr Suraj Patil (name change on request), 26, with this subject matter: "Beg for advice and help".

He has a loan -- of which Rs 4,000 is borrowed against his credit card and the balance is personal loan -- for which he is paying Rs 15,600 as equated monthly installment (EMI). Nothing wrong with that you may think. The shock registers only when I come to know that his net monthly income is Rs 9,800.

In the end his letter reads: "I am borrowing from my friends and relatives to meet my household expenses."  He had borrowed this money to invest in a company which had promised huge returns and then eventually went kaput. You may argue that didn't he calculate his financial inflows and outflows before borrowing money? Well he anticipated that he will repay the loan in double quick time as and when the company will give good returns. His letter was proof that sure did not happen.

Such examples are endless. The point here, however, is does any of you want to be in Suraj's shoes? Well, I don't think so.

All of us know that borrowing against credit cards is the worst debt a person can have as interest charges are as high as three percent every month or 36 per cent annually. However, people still over borrow on credit cards due to ease of obtaining finance compared to other sources. Add to this their borrowings from other sources. This is done without a thorough calculation if their income can support such loans and without providing for any adverse situations like the one faced by Suraj.

How to avoid over borrowing?

One does not have to be a genius to know this. All that they have to do is analyse their debt to income ratio.

What is debt to income ratio, you may want to ask. Well, it is the percentage of your income that goes towards payment of debt. This ratio is calculated as shown below:

Debt to income ratio = Total annual debt payments / Total annual take home pay

That is if you have a debt of Rs 10,000 and your annual income is Rs Rs 100,000 then debt to income ratio works out to (Rs 10,000 / Rs 100,000 = 1/10 or 0.1).

Total annual debt Payments: It means your entire annual loans payments. This includes car loans, home loans, personal loan, any payments towards credit cards and any other loans which you might have taken.

Total annual take home pay: This includes business/professional income or salary, any bonus receivable, dividend, interest, rent/royalty or any other form of annual income. Please note that employer provident fund contribution should not be taken into account.

When calculating this ratio do not include monthly expenses such as grocery, utility, travel expenses, entertainment and others. Only take into account cash outflow towards paying your debts.

Let's take an example to understand it better. The table given below is the cash flow statement of say Mr A:


Amount (Rs)

Total (Rs)






Rental income


Total cash inflow



Home loan


Car loan


Total cash outflow towards loans


(This is a hypothetical example and situations may vary from person to person)

Hence, the debt to income ratio here would work out to: 261,612/482,000 = .5427 (approximately) which as stated in percentage term would be 54.27 per cent.

Analysis of the ratio

The general rule of thumb suggests that this ratio should not exceed 45 per cent. That is taking into account your entire debt -- mortgage as well non-mortgage loans.

Anything above this ratio suggests that you are entering a danger zone and hence resist from borrowing any further. In the above example the ratio is 54.27 percent which is above the limit of 45 per cent. Hence, Mr A has already over borrowed and is in unhealthy financial situation. He should not borrow any further. Also, he should try and get in a reverse gear and obtain a ratio that would lead him to a safe zone.  

To help you judge even better the above ratio can be further broken into:

Total annual non-mortgage debt payments / Total annual take home pay

Total annual non-mortgage debt payments: It means all payments towards car loans, credit card payments, personal loans, loans from any private money lender and others.

Total annual take home pay: Same as mentioned above.

Let's take the above example and calculate debt to income ratio. In the above example the non-mortgage payment of Mr A is towards car loan. Hence, this ratio will be: 128,964/482,000 = 0.2676 which in percentage terms would be 26.76 per cent or rounded off to 27 per cent.

Analysis of the ratio

Ideal ratio calculated this way should be below or equal to 15 per cent. Not beyond that. Mr A's ratio is almost 27 per cent which is on higher side. Mr A should not borrow any further to make his situation more adverse.

The debt to income ratio tells a lot about your financial health. A lower ratio (below the two benchmarks calculated above) suggests a healthy financial life and a higher ratio suggest unhealthy financial life. Monitoring your debt to income ratio is a great way to keep a tab on your expenses. This also tells you when to stop borrowing more or your borrowing limit compared to your total take home pay.

The author is a financial consultant and can be reached at

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