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.