Part 3: A Look at a Critical Equation

By Casey McClurkin

This is the third installment of  our series on financial health  and wellness.

Last month, we talked about a ratio that can affect your credit score – the credit utilization ratio. About 30% of your credit score is comprised of your credit usage. As you continue to pay down balances, your credit score will continue to creep upwards. Keep up the good work!

Today, I’d like to discuss a new ratio – not one that will affect your credit score but it does impact your ability to get a personal loan or a mortgage from a bank or other lending institution: the debt-to-income ratio. This ratio is calculated by adding up all monthly debt payments (credit cards, mortgage, car payment, etc.) and dividing by your monthly gross income. For credit card payments, use the minimum balance due for this calculation. What this tells lenders is how much money you have to cover your monthly payments and obligations. An ideal debt-to-income ratio is 43% or less.

Let’s look at an example:

Your salary is $54,000 per year, which equates to $4,500 in gross income per month (your paycheck amount before taxes, Social Security, insurance, retirement savings, and any other financial obligations that are withheld). You have four monthly debt obligations: a $350 car payment and three credit cards with minimum payments of $250, $325 and $400 ($975 total) due each month. Finally, you’re applying for a mortgage with a monthly payment of $700.

Your debt-to-income ratio is 45%, calculated as follows:

In this example, your debt-to-income ratio is higher than what a bank or other lending institution would consider an acceptable risk when applying for a mortgage. Guidelines are set by the Consumer Financial Protection Bureau.* According to those guidelines, you still could be approved for a qualified mortgage in this scenario if your credit score is high enough and you can prove your “credit worthiness.” However, the best thing to do in this case to reduce your debt-to-income ratio would be to lower your debt payments or increase your income. If you can pay off just one of those three credit cards, you’re that much closer to qualifying for a mortgage.

Monthly Gross Income $4,500
Car Payment $350
Credit Card #1 (min pmt.) $250
Credit Card #2 (min pmt.) $325
Credit Card #3 (min pmt.) $400
Potential Mortgage Payment $700
Total $2,025 $3,000
Debt-to-Income Ratio (Total Debt/Gross Income) $2.025 / $4,500 45%

And the order in which you pay off those debts matters! You’ll want to pay off the credit card with the highest utilization ratio first. There are several strategies to paying off your credit card debts. Tune in next month when we’ll talk about debt reduction in detail. It’s one of my favorite topics and I’m looking forward to giving you an introduction to getting out of debt!

*To learn more about qualifying for a mortgage and what goes into a creditor’s decision about your application, visit the CFPB at www.consumerfinance.gov. You’ll find a wealth of knowledge about many financial topics. Look for “Buying a House” for more details on this particular topic.

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