Your credit score may be what you hear about the most, but it's not always the deciding factor for lenders.
Considering all the attention that credit scores get, it's natural to think that good credit means you're set. Many consumers have made this mistake and then been surprised after getting turned down for a loan or mortgage.
Although your credit score plays a big role in lending decisions, it's not the only thing that matters. Lenders also look at your debt-to-income (DTI) ratio. Mortgage lenders have even chosen DTI ratio, and not an applicant's credit score, as the factor most likely to make them hesitant to fund a loan request.
Before you apply for any sort of loan, it's important to understand how this measurement works and what qualifies as a good DTI ratio.
What is a DTI ratio?
Your DTI ratio is the amount of your monthly gross income you need to put toward debt payments. To calculate this, divide your monthly debt payments (your credit card payments, auto loan, mortgage, and any other debts you have) by your gross monthly income.
For example, say your gross monthly income is $3,000. You have $200 in credit card payments and a $400 auto loan payment, for a total of $600. Your DTI ratio would be $600 divided by $3,000, which is 20%.
Assessing your DTI ratio
Every lender has its own DTI ratio standards. However, if you want an idea of where yours falls and whether you should work on it, Wells Fargo has a solid set of guidelines:
- 35% or below: This is considered a stable DTI range. You should have money left over after paying your bills, and you can likely qualify for loans and credit cards.
- 36% to 49%: Your DTI ratio is manageable, but there's room for improvement. You may want to work on lowering it, especially if you plan to apply for a loan or line of credit soon.
- 50% or higher: Debt payments are eating up a substantial portion of your income, and it would be difficult to get approved for any new credit applications. Paying down debt is a smart financial priority to free up more money every month.
It's a bit more complicated if you'll be applying for a mortgage. Mortgage lenders consider two types of DTI ratio, and each one takes into account what your DTI ratio will be after adding in your projected housing costs.
The first is your front-end DTI ratio, which is how much of your gross income will go toward housing costs. A front-end DTI ratio of 28% or less will give you higher approval odds.
The second is your back-end DTI ratio, which is how much of your gross income will go toward all debt payments, including your housing costs. A back-end DTI ratio of 36% or less is recommended, although it can be possible to get approved if yours is higher.
Why your DTI ratio matters to lenders
Lenders look closely at your DTI ratio because it's a strong indicator of your financial stability and, in turn, the likelihood you'll repay what you borrow.
A high DTI ratio could mean you're already stretched thin with your monthly payments. If you're spending 50% of your gross income or more on debt, lenders will be wary of approving you for anything. A low DTI ratio, on the other hand, signals that you don't have too much on your plate and you're a good candidate for a loan.
Lenders can't get this information from your credit score. There is one factor in your credit score, your credit utilization ratio, that is similar to your DTI ratio. But it's based on how much you owe on your credit cards compared to how much total credit you have. Since it doesn't take your income into account, it doesn't give lenders a clear picture of how your monthly payment obligations compare to your income.
How to lower your DTI ratio
If your DTI ratio is higher than you'd like, it's a good idea to work on improving it.
One way to do this is to increase your income. But if your problem is that your DTI ratio disqualifies you from a mortgage or other type of loan, this method won't actually help right away. Lenders usually don't count income you just started earning in your DTI ratio.
Instead, you'd need to focus on lowering your monthly debt payments. And for most people, this is a more realistic solution than increasing income.
Here are a few tips on how you can lower those monthly obligations:
- Review your spending habits for the past few months. Look for places to cut back so you can put more money toward your debt.
- Prioritize paying down credit cards rather than installment loans. Paying down credit cards reduces your monthly payment amounts. With installment loans, the monthly payment amount generally stays the same. Until you pay the entire loan off, it won't lower your DTI ratio.
- Look into debt consolidation options that lower your monthly payments and interest rate. Balance transfer credit cards are a popular choice as they offer 0% intro APRs. You could also check out debt consolidation loans.
- Don't add to your debt. The only time you should apply for a new credit card or loan is if it's for debt consolidation.
Monitoring your credit is a smart financial habit. Since your DTI ratio is just as important, make sure you also keep track of that. By maintaining a low DTI ratio, you'll be less likely to have money troubles and more likely to get approved when applying for a loan.
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March 25, 2021 at 07:00PM
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