Debt-to-Income Ratios & Credit Scores

Credit scores and debt-to-income ratios are important considerations for lenders.

Credit scores and debt-to-income ratios are important considerations for lenders.

A credit score is your basic financial report card, summed up in a simple three-digit number (from 300 to 850) that reveals the state of your financial health. When you apply for a mortgage or other loan, the credit score will be one of the first and most important numbers the lender will consider. Another crucial factor, at least for mortgage lenders, will be your debt-to-income ratio (DTI).

The Ratio

For a person or a company, a debt-to-income ratio means the percentage that debt service takes out of your monthly gross. If you earn $10,000 before taxes and must send at least $1,000 of that money to creditors, your debt-to-income stands at a reasonable 10 percent. The higher the ratio, the more income that goes to servicing debt, and the more limited your ability to repay new debts. DTI includes any recurring legal or contractual obligation, such as loan payments, car payments, child support or taxes paid to the IRS, with an installment agreement.

Debt Ratios and Loans

Not all lenders consider debt ratios when making their decision on a loan. Credit card applications, for example, don't request information on your current debts, but they do want to know your annual income. Mortgage lenders and bank loan officers (for a small business loan, for example) will be asking for a calculation of DTI. A ratio of 36 percent is the standard maximum for home lenders; this figure includes any future payments you'll be making on the mortgage. For FHA-backed mortgages, maximum DTI is 43 percent as of 2012. Some lenders break out future housing expenses as well and limit those to 28 percent of your income (for FHA-backed, 31 percent). If the ratios are higher, you either don't get the loan or must pay a higher rate of interest.

Credit Scores

Your credit score is also known as the FICO score, for Fair Isaac Corporation, a company that develops financial scoring systems for businesses and credit-reporting agencies such as TransUnion. Several factors go into your credit score, including payment history and utilization rate: the ratio of debt you have to the credit limits on your revolving accounts ($1,000 credit limit, $100 balance = 10 percent utilization). A score of 850 means perfect credit, while 300 means you're the nation's worst credit risk. Mortgage lenders will charge the lowest interest to borrowers with high scores, and offer loans with higher rates, if at all, for lower-scoring applicants.

FICO and DTI

Your DTI ratio is not taken into account when your FICO score is calculated; thus, you could be paying a very high percentage of your income to creditors, but as long as your payment history is good, your debt utilization is low and you're never late with payments, you can still enjoy all the advantages of a high credit score. However, mortgage lenders want a more complete picture. They will demand a look at the DTI ratio, and their lending guidelines may restrict loans on that basis alone.

 

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