Lenders look at more than just your credit score, including your debt-to-income.
A strong foundation for financial health lies in maintaining your debts at a manageable level. The general idea being to keep yourself in a positive equity position when looking at your debt-to-income ratio. While your debt to income ratio doesn’t directly affect your credit score, it is an indicator of money management.
Sometimes we forget a lending decision isn’t simply based on your score. Other factor on your report are taken into account. Your debt-to-income ratio helps a lender determine if you can “afford” to take on new debt, whether you technically qualify for it or not.
This benefits multiple credit situations. Those with poor credit, good income, and a very low debt-to-income ratio may find themselves qualified with certain lenders.
Consumers with good credit and a low debt-to-income should have little to no problem taking on new credit. The situation to avoid is: poor credit, high debt-to-income ratio, and low income. This is a very high risk scenario to most all lenders.
What exactly is a debt-to-income Ratio?
The debt-to-income or DTI ratio refers to the comparison of the monthly debt expenses to the monthly gross or net income. It’s calculated by dividing all your monthly debt payments by your monthly gross income.
Here, your monthly debt payments include the sum of all payments towards your debt such as credit card payments, loan payments, car loans, and other debts. Your monthly gross income includes the income before deduction of taxes. The result is your debt-to-income ratio.
For example, if your monthly debt payments are $2000. This includes $400 in credit card payments, $200 in car loans, and $1400 in rent. If you earn $ 60,000 annually, the gross income would be $5000 per month. Your DTI is calculated by dividing $2000 by $5000, which gives you 0.4 or 40 percent.
In this particular example, a lender might see this as a risky debt-to-income. The ideal DTI is under 36%.
Why is Debt-to-Income Ratio important?
Your DTI is a benchmark which gives lenders an idea as to how much debt their borrowers can afford to take on. Lenders can use this information to determine if you can afford the payments of your requested loan. They may also use this ratio to determine the maximum amount they’re willing to lend you.
However, on its own, the DTI ratio will not affect your FICO credit score. With that said, it’s a critical part of your overall credit health and can have a direct impact in a credit decision.
Debt to income doesn’t contribute directly to a consumer’s FICO score but plays a role in your buying power.
Even though the DTI ratio is not used to calculate your FICO credit score, you should still pay close attention to it. DTI is a big factor deployed by lenders to decide whether to lend to you as it features your ability to take an additional financial obligation.
Because this number is a window into your financial obligations vs your income, it helps to determine buying power. Buying power is a consumer’s potential for credit approval. Your credit score itself is one factor used to determine buying power.
DTI effects lending of credit cards, car loans, mortgages, etc.
In addition to credit cards, lenders examine your DTI before lending you a mortgage. The maximum DTI required for a mortgage is 43%, but you should aim for a DTI of 36% or less. It also plays a key factor in whether you receive a credit card when you apply.
What happens when you have a high DTI ratio?
If DTI is more than 40%, lenders are likely to consider you a high-risk borrower, regardless of how good your FICO credit score is.
A high debt-to-income of 37% or more is an indication to the lender that your debt consumes too much of your income. Their concern is lending you more, raising your debt-to-income, and a disaster strikes. If your debt is more than 40% of your income, it’s difficult to handle an emergency while maintaining your payments.
Your DTI will pose too high of a risk for them to count on you paying a new debt as required.
Lenders use DTI in conjunction with FICO scores and report history to make lending decisions.
A high debt-to-income ratio can prevent you from acquiring any lines of new credit. DTI does play a more significant role in large purchase such as cars and homes. But, it’s also considered for credit card decisions and other personal loans.
Credit cards are generally high interest debts. They may be willing to lend to a consumer with a high debt-to-income ratio simply because of a good credit score. To a lender, this consumer wants to maintain their good credit, and is more likely to have a flexible budget for new debt. Of course, they also want that 25% interest rate 🙂
Your debt-to-income ratio in conjunction with your credit scores greatly affects lending decisions. This is true for credit card approvals, mortgage loans, car loans, and more. If you can manage to keep your debt-to-income ratio low, you may qualify for some lines of credit despite a low credit score.