Loans have become widespread in our lives and people often use more than one – they pay off a home mortgage and a consumer loan, lease a car, shop with a credit card. Loans can bring benefits and improve the standard of living provided that they are used wisely and managed skillfully. Otherwise, the road to financial problems is short. Therefore, it is extremely important to approach your credit obligations responsibly and realistically assess your financial capabilities. This way, you will have more certainty that the amount of debt you take on is in line with your capabilities and that repaying it would not disrupt your financial stability in the future.

Maintaining a healthy level of debt is key to your long-term financial sustainability. Excessive debt limits savings and investment opportunities, can lead to difficulties in covering basic expenses and increase the risk of becoming over-indebted with all the serious consequences that this entails.

Sometimes taking on a financial obligation makes sense in light of economic conditions – for example, when the interest rate on a loan is close to the inflation rate. In these circumstances, you will lose money in nominal terms, but in terms of purchasing power you will actually gain.

 

How is the level of indebtedness determined?

The debt-to-income ratio, also known as the DTI ratio, is commonly used to determine the level of indebtedness. It shows how much of your income is used to repay your loan obligations. It is always calculated by banks when you apply for a loan to assess your creditworthiness. It makes sense – if you have a high level of debt, then the risk of problems with servicing another loan is also high. The opposite is also true – with a low level of debt, the risk of problems arising in servicing it is lower.

The DTI ratio is calculated by dividing the total monthly amount of loan payments by the total amount of net monthly income. The result is presented as a percentage.

When calculating total liabilities, the due installments on consumer, mortgage and other loans, leasing, credit cards, commodity loans and others are included. This also includes the monthly rent for housing, if you pay such. As for income, banks can report all monthly receipts or only some of them – salary, payments under a civil contract, rental income, etc. As a rule, banks make calculations based on net monthly income – this is your disposable income after the due social security contributions and taxes have been paid.

For example, your monthly mortgage payment is 900 EUR, your consumer loan for repairs and furnishings is 200 EUR, and your car lease is 400 EUR – a total of 1500 EUR. Your net monthly income from salary is 3000 EUR. Under these circumstances, the debt-to-income ratio is 50%.

 

What debt-to-income ratio is acceptable?

In principle, it is good to have no credit obligations or to use them only for constructive purposes (acquiring your own property, investing in education, etc.), but this is often unattainable in reality. The important thing is to maintain an optimal level of debt in relation to your life situation. This way you will have financial stability and enough free funds to save and invest, to cover unforeseen expenses without any problems. A low level of debt has another advantage – it provides you with easy access to credit on favorable terms.

Determining the acceptable level of the debt-to-income ratio largely depends on the specific situation, the type of loan, and your financial goals. Banks and other financial institutions have their own policies regarding the limits of this parameter, which they follow when granting loans.

However, there are some generally accepted recommendations. According to them, the ratio of total debt (monthly payments on all credit obligations) to monthly income should not exceed 30-35%. The ratio can also be calculated for mortgage debt alone. The monthly payment, together with insurance and tax costs, compared to monthly income should not exceed the limit of about 25-30%. For consumer loans, the recommended limits are about 5-10% of monthly income. The upper limit of the DTI ratio, above which it is not reasonable to grant additional credit, is often considered to be 50%.

 

How to manage your debt?

The basis of successful debt management is good planning of financial expenses and keeping a budget. This way you will always be aware of what funds enter your household each month, what your expenses are, their structure and of course how much is spent on paying loan installments. On this basis, if you need to take out a new loan, you will be able to objectively assess whether it is wise to do so and what the optimal amount of the monthly installment for servicing it would be. When analyzing the budget, you will easily notice the first signs of financial difficulties and will be able to take measures in a timely manner - limiting some of the expenses, optimizing debt payments, increasing income. Having an emergency fund is also an important condition and protects you from unnecessary debt.

 

It is essential for effective debt management to take advantage of the various opportunities for reducing it and optimizing the costs of servicing it. Here are some of them:

• Early repayment of a loan

If you have the funds at a given time, you can consider paying off your loan obligation in full or in part. This will free up more space in your budget for other important financial goals. With consumer loans with a variable interest rate, you do not owe a fee for early repayment, but such a fee may be required for loans with a fixed interest rate. With mortgage and housing loans, you will not pay a fee if you have made at least 12 monthly installments.

• Refinancing a loan

Refinancing a loan means taking out a new loan with more favorable terms to repay an existing debt. It is possible to pay off an old loan or consolidate more loan obligations to cover with the funds from the new one. By refinancing, you can achieve a lower interest rate, optimize the term of the loan to reduce monthly installments, improve some loan conditions related to its servicing, such as fees and others. For refinancing, you can contact your servicing credit institution or look for better conditions at another one. In any case, however, you should carefully consider this step. Evaluate all the costs associated with granting a new refinancing loan to make sure that it will bring you real benefits in the long term. It is better not to wait for a moment of financial difficulties to seek refinancing. You can get the most favorable conditions if you have good creditworthiness and regularly service your obligations.

• Order of loan repayment

According to economic logic, those loans with the highest interest rate should be repaid first. In this way, the borrower will save the most money.

Debt is not necessarily a bad thing. A loan can allow you to replace the rent of a home with a mortgage payment, start a business or invest in your education and qualifications, so as to increase your income in the future. As long as you use debt wisely and manage it wisely, it can significantly help you improve your standard of living in the long term. The general rule, however, is to think carefully before taking on debt, and to keep it to a moderate amount. Taking on debt (debt assumption) should be in line with your current and future income.