Understanding the Debt-to-Income Ratio
When it comes to your credit report, it’s not just the amount of credit you have that matters. Potential lenders will look at your score and your income levels to determine what your debt ratio is. Different companies will have different requirements, but it’s important to understand how the trilogy of credit score, outstanding credit, and debt ratio all work together.
Your debt-to-income ratio is simply your monthly debt payments divided by your gross income. It shows potential lenders how likely you are to be able to repay a loan in the future. It’s easy to determine what your ratio is. Simply add up the monthly payments you make on all debts, including car loans, mortgages, personal loans, and credit cards. Then divide this number by your gross monthly income, or the money that you earn before any taxes, health insurance premiums, or other deductions are taken.
Research shows that people with higher ratios are more likely to have difficulty repaying mortgages and other debts. As your ratio rises, it becomes harder to find good financing terms on personal loans.
The Impact on Credit Score
The debt ratio does not have a direct impact on your score, but it does play a vital role when you request financing. The lending agency will use the information contained in your credit report to determine what your minimum monthly payments will be if they approve the loan. A standard rule of thumb for lenders is that the debt ratio should be at or below 36 percent. In general, the highest that a mortgage lender will go is 43 percent.
Credit utilization is determined by the credit reporting companies, and it plays a major role in your overall score. To determine this number, the agency takes your total balances on all credit cards and divides it by your available limits. Ideally, the amount you have charged on cards should not exceed 30 percent of the credit line.
Overcoming the Challenges
If you have a high utilization percentage, then getting financing will be difficult. This can be overcome if you get a better job and your debt-to-income ratio suddenly drops. In this case, lenders may overlook your slightly lower credit score provided you have a solid payment history. It’s easy in this situation to use the improved income levels to take out more debt and boost your lifestyle. However, you’ll probably be better served by taking the extra income and paying down the existing debt. As you do so, you’ll have lower monthly payments, your debt ratio will improve, your credit score will rise, and you may find better financing rates when the time comes.
Take care of your credit score and overall financial health by paying attention to the debt to income ratio. While it won’t show directly on your credit report, it still plays a major role in loan approvals. You can work to improve this ratio by condensing loans, paying off bills, and striving to reduce your overall debt.