For most of us, our credit score is a number that we don’t think much about until there’s a problem. Maybe we’re trying to take out a car loan, or attempting to qualify for a mortgage, and all of a sudden there are red flags being raised about our financial decisions over the years.
In other words, many of us tend to be clueless about our financial standing – and more specifically, about our credit scores – until it’s too late.
I’ve written elsewhere about how completely most of our public schools fail our kids when it comes to managing, saving, investing, and generally understanding money. What most of us do manage to come away with, however, is a general idea that the higher our credit score, the better off we are. That’s good, but it’s only a start.
Furthermore, the many variables that go into calculating a given person’s credit score are frequently misunderstood. For example: many still believe that canceling unused credit cards will have a positive effect on your credit score, or that being debt-free automatically correlates to a better score.
The good news is that there might be a better metric for determining one’s overall financial well-being.
Goodbye Credit Score?
The nation’s financial institutions use a number of factors to help decide whether to approve a loan request. Credit score has historically been one of these, but FICO has recently turned their attention instead to another factor that might play an even larger role: debt-to-income ratio.
Debt-to-income ratio (DTI) now tops credit scores and net worth as the primary factor that determines whether a credit applicant will be turned down or not.
Granted, if you’rebound for rehab because your gambling addiction has crippled you financially, you likely have more serious considerations than a single number.
In any event, a recent FICO study revealed that almost 60% of surveyed risk managers now consider DTI as their first and most serious consideration when appraising a person’s creditworthiness.
What Is DTI?
Very simply, your DTI indicates how likely it is that you’ll be able to afford to repay a given financial obligation. These can include mortgage payments, car loan payments, or student debt.
It’s easy enough to determine your DTI: it compares your gross income (before taxes) to your proposed expenses (house or car payments, etc.). The latter includes the principal amount of the loan payment along with applicable taxes, interest, and even insurance expenses.
Risk managers tend to look more favorably at applicants who will end up with a housing expense ratio of less than 28% of their monthly take-home pay. As indicated by Freddie Mac and Fannie Mae, the average DTI of approved home purchasers was around 22%.
There’s a second component that goes into assessing a borrower’s DTI, however, and it’s called the “back-end ratio.” Perhaps unsurprisingly, this takes into account the rest of your recurring debts and compares them to your income. This bundles together things like general housing expenses, credit card and student loan debt, and other regularly scheduled payments.
According to federal mortgage standards, back-end ratios for approved borrowers generally top out at around 43%. If you fear you may be close to the cutoff, you can make use of the “Know Your Options” site, courtesy of Fannie Mae.
Ranking Credit “Turn-Offs”
If DTI is on its way to becoming the #1 “turn off” for lenders, then repeated credit applications come in at #2, followed by credit score at #3. The former indicates that the applicant may be seeking out new outlets for their spiraling debt, while the latter is best kept above 700 if you want to maximize your chances with most lenders.
At the end of the day, what this tells us is that things like DTI and credit score isn’t just a tool for lenders; it’s something each of us can calculate for ourselves, and should check on regularly. Keeping an eye on your financial standing, and the various ways it’s evaluated, could save you the inconvenience and potential embarrassment of being rejected out-of-hand by a lender.
