We’ve talked about the primary factors of credit scoring: payment history, amount owed and credit utilization, credit history, inquiries and account diversity. While it’s true that focusing on these factors could lead to a place in the 800 Club, there’s another factor that demands attention: your Debt-to-Income (DTI) ratio.
Your DTI ratio is measured by comparing your gross annual income to the debt you owe, including:
- Auto loans
- Student loan payments
- Personal loans
- Alimony, child support and other financial judgments
- Minimum credit card payments
For example, suppose you earn $120,000 per year, or $10,000 per month. Your monthly debts include:
- Auto loan: $375
- Student loans: $450
- Child support: $500
- Minimum credit card payment: $300
Based on these numbers, your DTI ratio is a respectable 12.2 percent ($1,220/$10,000). You intend to apply for a mortgage this year and aren’t sure how much you can afford. With a low DTI ratio and a good credit score, you probably won’t have trouble qualifying for the maximum loan amount allowed by federal law, which is 43 percent of your gross income, or $4,300 per month. This decision could affect your credit in a few ways:
- Missed opportunities. While some lenders prefer applicants with a DTI ratio of 20 percent or less, others will approve loans with a DTI ratio in the high 30’s. Hedge your bets by aiming for a ratio on the lower side. This will help you mitigate risk and allow future lenders to have confidence in your repayment skills. In this scenario, that means your monthly mortgage payments should hover around the $1,500 range, a far cry from $4,3000.
- High credit utilization. The phrase, “maxed out” is synonymous with credit damage. The higher your debts, the greater chance of increasing your credit utilization ratio, or the amount you owe versus your total credit limit. This ratio generally applies to credit card balances, but it accounts for 30 percent of your score. As both ratios increase, so does your likelihood of credit damage.
- Decreased savings. A high DTI ratio means you’ll have less liquid cash to save each month. Although income is not a direct factor of credit scoring, an emergency fund allows you to avoid relying on loans and credit cards to make ends meet, two scenarios that do carry long-term consequences. Maintain manageable debts. A safe DTI ratio is a reflection of good choices.
The bottom line: Your DTI ratio may not be a credit-scoring factor, but its influence has the power to affect the things that do determine credit. Approach DTI as you would credit utilization. This strategy will help you maintain financial stability.