Debt Ratios Simplified
By Jill Terry
Loan officers consider several key pieces of information about you when deciding whether you’re credit-worthy. One key piece is your debt ratio, or the percentage of debt to income (sometimes called a “debt to income” ratio).
What’s a Debt Ratio?
Just as a company’s liabilities are weighed against its assets to determine its net worth, a similar process is followed with consumer credit. Banks want to make sure your income is considerably higher than what you owe. Percentages do vary among banks and among different types of credit, but the banking industry in general prefers that a credit applicant’s debt ratio be less than 40%. (So, if your gross income is $3,000 monthly and your expenses are $1,200, your debt ratio is 1200 divided by 3000, or 40%.) Some banks use gross income, while more conservative lenders use net income. Feel free to ask which figure your prospective bank uses.
What’s Considered Debt?
Unfortunately, a bank’s definition of debt is broader than you might think. Here’s a brief list of typical debt components:
- Credit cards
- Rent or mortgage payments
- Homeowner dues or fees
- Student loans
- Alimony or child support
- Day care expenses
How is Debt Calculated?
Be forewarned that credit card debt may not be calculated as you’d expect. Banks may calculate debt in one of the following ways:
- By asking to see your statements to get the minimum payment amount.
- By taking 1%, 3%, 5% or even 8% of your balance and assuming that’s your monthly payment.
- By taking 1%, 3%, 5% or even 8% of your credit limit and using that as your monthly payment (because that’s the most you might ever pay on that particular card).
This last method holds serious consequences for applicants who have several credit cards with zero or low balances. Just having the cards hikes up your debt according to some bank’s standards because some lenders will evaluate your creditworthiness based on how much you could borrow not how much you have borrowed. So, if you thought it might be a good idea to have lots of credit in reserve, rethink your plans. It’s best to keep the number of cards you have to a minimum–only keep those cards you absolutely need. In this case, more is definitely not better.
What’s Considered Income?
Be sure to evaluate your credit situation from every angle and to take advantage of any aspect that might improve your standing. Income is not just your salary. It includes any payments you receive on a regular basis, such as government assistance benefits, part-time work, or even stipends from your father. Banks are reluctant to accept income other than salaries, so expect some resistance if you’re claiming income that doesn’t fall in the traditional salary category. You’re likely to be asked for some proof of the continuance of any non-salaried income, a feat that is often difficult enough to make applicants either give up or resign themselves to being declined. To verify the continuance of government assistance payments, simply present the bank with letters from the government agency that details the amount and duration of the payments.
Other Methods of Calculating Debt Ratios
Some banks add a certain percentage to your debt ratio for every dependent in your household. A large number of dependents means more day-to-day expenses. In response, banks apply a special formula that ultimately increases your debt position. If this issue might negatively affect your application, be sure to inquire whether your bank includes this item in its calculation before you apply. If it does, look for a lending institution that doesn’t use this method