When you borrow money, there is a chance that you might default. Debt management ratios tell lenders about your level of indebtedness and whether you are a good or bad credit risk. Typically, creditors look at your total debt and income to make a determination of whether to extend you credit. The higher the ratio of your debt to assets or income, the less likely you'll be approved for a loan.
Debt Management Ratio
Having debt is not necessarily a bad thing, but having too much debt reduces the chances of getting approved for a loan. Lending institutions look at debt as a percentage of your income and assets. Each lender has its own guideline when it comes to debt management ratios. Creditors categorize debts based on amount, length of time until it is paid off and whether the debt is secured and unsecured. Secured debt is debt backed by an asset such as a house or car. If you can't make the payments, the lender can repossess the asset. Credit card and personal loans fall under the category of unsecured debt. Your total debt is all your secured debt, unsecured debt and your other financial obligations.
Housing debt includes principal, interest, real estate taxes and homeowner's insurance on your primary residence. If you don't own a home, lenders use your rent expense, as this makes up a large part of your monthly financial obligations. A mortgage lender prefers that the ratio of your housing debt to your gross income not exceed 28 percent. This is also referred to as the front-end ratio or the housing expense ratio. The ratio tells the lender how much home you can afford to buy. To calculate the ratio, multiply your annual salary by 28 percent then divide this amount by 12 months. For example, if your earn an annual salary of $72,000, the front-end ratio is $1,680 (($72,000 x .28)/12).
Adding all of your debts together gets your total debt obligations. This includes your mortgage, car loans, student loans, credit card bills, child support and alimony or your other debt obligations. The amount of your debt should not exceed 36 percent of your gross income, which is also called the back-end ratio. Your gross income is your total salary before any taxes and other deductions. To calculate the back-end ratio multiply you annual salary by 36 percent and divide the result by 12. For example, if you earn $90,000 a year, your maximum allowable debt-to-income ratio is $2,700 (($90,000 x .36)/12).
Your credit score, which ranges from 300 to 850, also plays a large role in whether you receive approval for a loan. Factors that affect your credit score include type of debt, total amount of debt, payment history and public records such as whether you have a judgment against you or owe child support payments. Proper management of your debt will help your credit score. Having a good credit score, considered to be 700 or above, means your loan is likely to be approved at a lower rate of interest. A low credit score means being denied altogether or having to pay a higher interest rate.
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