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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
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