The world of credit: Debt ratio--Income and creditJohn HudockCredit scoring tips
We can divide the debt ratio into two categories:
1. Debt-to-income ratio; and
2. Credit debt ratio.
The debt-to-income ratio is established as a conforming rate of
36 percent. This ratio is the maximum ratio of debt and income
illustrated by conservative lenders. The credit ratio is obtained
by comparing the original amount of credit extended to a consumer
by his creditors and the current total balance from each open
account. The debt ratio is absolutely crucial to anyone extending
his credit. The debt-to-income ratio (DTI) is a major indicator of
a consumer's real financial picture. It is definitely the lending
industry's measure of fiscal health, although it does not enter
into FICO's interpretation of your credit score. The DTI is
determined by dividing monthly minimum debt payments (not including
rent or mortgage, food, utilities and entertainment) by gross
income (monthly). As an example, if you have a gross monthly income
of $3,000 and you are making minimum payments of $1,000 on debts
(loans, credit cards, etc.), that equals a debt-to-income ratio of
33 percent ($1,000/$3000 = 0.33). This is a good DTI—not
great. This formula will vary slightly from lender to lender, but
only slightly. Some include the mortgage but raise the acceptable
ratios while others do not. While variations will result in
different percentage outcomes, the overall concept is the
same—a debt-to-income ratio compares debt load to income.
Lenders and financial advisors generally agree that a debt ratio
(not including a mortgage, utilities, etc.) of 10 percent or less
is great. Debt ratios at 20 percent or higher are concerns as one
financial emergency could hurt the consumer for seven years or
more.
Although a recent article in The Motley Fool stated, "Still, far
be it for the credit card industry to poo-poo your request for a
line of credit. Even if your debt-to-income ratio is 50 percent or
more, you'll probably have little trouble qualifying for a credit
card. Never mind that mortgage lenders preach that your debt
level—including mortgage and all revolving unsecured
debts—should not exceed 36 percent of your gross monthly
income. In their eyes, that leaves just eight percent of your
income for non-mortgage debts."
Calculate your own debt-to-income ratio, before you try to
explain it to anyone else. Use all monthly calculations:
A. Total monthly debt payments
• Mortgage payment (including property taxes and insurance)
or rent
• Home equity line of credit or loan payment
• Car payments
• Revolving credit payments (furniture, appliance loans,
etc.)
• Any student loan payments
• Minimum credit card payments (suggest four percent of high
limit)
• Other loan payments
• Child support payments
B. Total monthly income
• Monthly net (take home) pay
• Annual bonuses and overtime, converted to monthly
income
• Any other annual income, converted to monthly income
A divided by B = Debt-to-income ratio
Most lenders will accept a 36 percent or lower debt-to-income
ratio as good. This is a barometer—you cannot use the same
formula for everybody. You should consider the number of dependents
and any unusual expenses and spending patterns that will affect how
much debt you can reasonably handle; but, generally, anything over
36 percent would be uncomfortable for the conforming lender. I use
the following scale for debt-to-income ratio:
• Excellent—Less than 30
percent.
• Good—30 percent to 36 percent. You
won't have any problem with lenders, but budget to bring the DTI
below 30 percent.
• Be concerned—36 percent to 40
percent. Sub-prime lenders will still give you a loan, but you may
struggle to make your payments.
• Seek credit assistance—40 percent or
higher.
Some interesting facts:
• Business Week says that total household debt in the U.S.
was more than 100 percent of our disposable annual income last
year.
• The total consumer debt is at $1.7 trillion (you can
visualize $1 trillion as a stack of $1,000 bills placed one on top
of the other, flat side on top of flat side, reaching 67 miles
high).
• The personal credit card debt carried by the average
American is $8,562 and the total interest paid in 2001 was $50
billion—an average of $1,000 in interest per consumer. The
average consumer carries eight cards and 20 percent of the cards
are maxed out.
• There were 1.3 million credit cardholders declaring
bankruptcy last year. Bankruptcies have exceeded one million per
year every year for at least seven years.
• If you keep your DTI low, you will more likely qualify for
the lowest interest rates and best terms when you apply for
credit.
• America has a total debt of $32 trillion in household,
business, financial and government sectors, or $115,322 per man,
woman and child.
Your debt-to-income ratio limit is only one part of qualifying
for a home loan. Two other major considerations are the FICO credit
score and the loan-to-value (LTV) of the property. The scoring
model that FICO is currently selling is a reflection of your past
credit habits, not so much your current or future credit habits,
which could be totally influenced by education. FICO is concerned
about education as they feel you would be able to manipulate your
credit score. I have developed a scoring system that considers your
past habits, your current income, your debt-to-income ratio and
your credit ratio. I feel that it is the most accurate numerical
value that can be placed on an individual relative to their
financial stability. The current FICO score does not reflect
temporary changes in your income. It is totally biased in its
conclusions and holds you accountable for situations that occurred
seven to 10 years ago. I have seen too many individuals being
denied loans or paying a very high interest rate because no one has
explained to them the basic facts on credit.
Recently, syndicated radio talk show host Clark Howard, who
regularly reports on consumer issues, announced that 95.1 percent
of the individuals receiving a credit counseling voucher, which is
now required for filing bankruptcy, are still filing for
bankruptcies. I was confused with those figures, since the recent
bankruptcy changes went into effect on Oct. 17, 2005. The six-month
counseling requirements could not have been met. The Bankruptcy
Abuse Prevention and Consumer Protection Act of 2005 requires those
filing bankruptcy to obtain credit counseling from an approved
agency in the six months immediately prior to filing bankruptcy. A
certificate of completion obtained from the credit counseling
service must be submitted with the bankruptcy petition. If this 95
percent figure is accurate, there certainly must be a problem with
the advice these people are being given. Bankruptcy is the last
resort and should be avoided at all costs. We provide free methods
as an alternative to bankruptcy and found that many creditors are
willing to set up payment programs with affordable payments as an
alternative. Less than 10 percent of individuals meeting with us go
on to file bankruptcy.
Fight identity theft by monitoring and reviewing your credit
report. You may request your free credit report online, by phone or
through the mail. Free credit reports requested online are viewable
immediately upon authentication of identity. Free credit reports
requested by phone or mail will be processed within 15 days of
receiving your request. The three nationwide consumer reporting
companies have set up one central Web site, toll-free telephone
number and mailing address where you can order your free annual
report. To order, visit www.annualcreditreport.com, call (877)
322-8228, or complete the annual credit report request form and
mail it to:
Annual Credit Report Request Service
P.O. Box 105281
Atlanta, GA 30348-5281
If you need a copy of this form, contact me and I will e-mail,
fax or send it to you via U.S. mail.
John Hudock is president of The International Credit Club
and The World of Credit, two companies specializing in credit
report problems and scores. He also has online continuing education
courses on credit approved by the Pa. Department of Banking and the
Pennsylvania Department of Continuing Legal Education. John can be
reached at (877) 829-5432 or e-mail
[email protected]. He invites e-mails on
any credit topic, will answer each one and publish any that will
benefit his readers. Please be specific with your
questions.
