Probability Ratios for Credit Decisions

When you apply for a mortgage loan, ask your credit union for auto financing or seek a personal loan from a bank, the lending institution with which you are working will study your debt ratios to determine whether you are a high or low risk to default on your mortgage payments. It's one way that financial institutions can protect themselves from making bad loans.

Probability Ratios

Lenders want to loan money to those borrowers who have the highest probability of paying back their loans on time. To help them do this, lenders look at the debt ratios of borrowers to determine the likelihood that they'll struggle to pay back a particular loan. If your probability ratios aren't in line with what banks and lenders are seeking, you'll either fail to qualify for a loan or you'll have to pay higher interest rates on the money that you borrow.

Debt-to-Income

One of the most common ratios that lenders consider is your debt-to-income ratio. This ratio compares all of your monthly debts to your gross monthly income. In general, lenders want your total debts each month -- which includes your monthly home loan payment -- to total no more than 36 percent of your gross monthly income. Lenders feel that you are more likely to struggle to pay back a particular loan if you're already burdened with too much monthly debt.

Front-End Ratio

Your front-end ratio is a probability ratio that compares only your housing costs to your gross monthly income. Lenders want your monthly housing costs, which include your mortgage payment, property taxes and any housing assessments you might face, to equal 28 percent or less of your gross monthly income. Again, lenders feel that borrowers who have higher front-end ratios are more likely to eventually default on their new loan payments.

Improving Your Probability Ratios

You can improve your debt ratios, and make yourself a more attractive borrowers to lenders, in two ways: You can either boost your gross monthly income or lower your monthly debt obligations. Of course, if you do both, your debt ratios will fall even faster. Be careful, though, to never take on more debt obligations than you think you can comfortably afford to pay back, no matter what your probability ratios say.