Creditors assess your loan application using a number of factors -- your payment history, your income and the total amount of your current debts. Your credit score helps them assess your payment history, but your debt-to-income ratio is arguably a larger part of the picture.
Why It Matters
When you apply for a loan, such as a mortgage, auto loan or credit card, the creditor has no assurance that you will repay it -- only clues based on your previous behavior toward creditors and your present financial ability to make payments. The creditor can review your credit history through a credit report, which credit reporting agencies compile based on your tendency to pay your bills, whether on time, late or not at all. Depending on your financial habits, the agencies each assign you a number between 300 and 850, your credit score. A credit score of 700 or higher puts creditors at ease about lending to you.
How It's Different from Your Credit Score
Since your credit history can span over years, creditors often need more information to assess you as a borrower. After all, the fact that you dutifully made payments on a loan five years ago says nothing of your ability to repay that same loan today. This is where your debt-to-income ratio is helpful. Creditors compare the amount of money you currently earn to the total amount of money you owe. They determine whether you can reasonably repay the loan based on the amount of money you have left after fulfilling your responsibility to repay other loans.
How to Calculate Your Ratio
You can calculate your debt-to-income ratio before you even apply for a loan. First, total your monthly debts, including auto loan, mortgage, credit card, school loan, alimony and child support payments. Then, divide the sum of these debts by your total monthly income. For example, if your monthly debts total $500 and you make $4,000 a month, your debt-to-income ratio is 12.5 percent. Creditors may exclude some sources of income, such as scholarships and veteran's benefits, when calculating your ratio, but this calculation can help you assess your finances yourself.
Suggested Ratios
Creditors' debt-to-income standards vary, so one creditor may accept your loan application while another denies it. In general, creditors lend at lower interest rates to applicants with debt-to-income ratios of 36 percent or lower. When applying for a mortgage, your chances are better if the mortgage and any other housing expenses do not total more than 28 percent of your income. Remember that your ratio changes with every loan you acquire, so recalculate your ratio before applying for new loans.
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