Debt Ratio
Ignorance is Not Bliss
By Daniel Muniz

For people concerned with their credit, there is sometimes an obsession with their three-digit credit score. Although the credit score does play a significant part of the lending process, there is a two-digit number that can be just as important but far too many are simply unaware of it.

It is your debt ratio.

And it doesn’t take much to calculate this figure yourself.

Although many consumers may be aware of the basics of credit and know how to keep a good score (by exercising responsible credit behavior), there are some who are oblivious to the impact that the debt-to-income ratio can have on their finances. In conjunction with your credit score, this ratio plays an important role in obtaining the best possible terms for just about any kind of loan such as a mortgage, car, credit card, etc.

Just as the name implies, the debt-to-income ratio (sometimes known as the back-end ratio) is precisely that. It is your total debt compared against your total income.

Simply add your total your credit expenditures that you pay every month, which is more or less the stuff that shows up on your credit report. These contractual obligations are like payments for mortgage (or rent), car, credit card, and other loans. That is your total monthly debt which is also known as recurring debt.

Do not include any personal expenses like groceries, utilities, entertainment, transportation, etc.

Next, add all of your revenue sources for the month.

Now take your monthly recurring debt and divide it by your monthly income.

Here is an example. Suppose you earn $48,000 a year which is $4,000 a month. Next, suppose all of your total monthly recurring debt is $1,800. Divide $1,800 by $4,000 which is a debt ratio of 45 percent.

However, the magic number for a "good" debt ratio is actually anything below 36 percent and the lower the better.

So anything above 36 percent and all of a sudden a creditor will be questioning your credit worthiness because that means that more than a third of your income is dedicated to servicing your debt. And the higher the ratio is, then the higher the risk because you do not have abundant discretionary income available to satisfy for your obligations. Consequently, the terms and interest rates become increasingly unfavorable because of this risk.

And if the ratio rises past 50 percent, then it becomes increasingly difficult to find any reputable lender although there are plenty of predatory ones out there who will loan you money with outrageous interest rates.

But what about the consumer who has paid all of their bills on time and was never late?

The dispassionate answer is “so what.”

And that is why the debt-to-income ratio is so important. In conjunction with your credit score, it helps paint a picture of your ability to handle a new contractual obligation.

It may sound completely unfair to someone who has paid every bill on time that they are a credit risk because of a high debt ratio but lenders have to make informed decisions based on the information available.

But available information is actually a wild card. A consumer may have contractual obligations that do not show up on a credit report thus a lender is unaware that they exist. A loan application will ask you to volunteer such additional information but there really is nothing stopping you from leaving it blank, thus improving your debt ratio. In fact, lots of people do exactly that in order to obtain much better terms and interest rates.

It is at that point where good judgment is needed.

Far too many consumers have fallen into the trap of overextending themselves with debt.

And it really is a ruthless trap because certain lenders don’t want to know anything more than they have to so they can approve that credit application. In an instant, your true debt ratio can be well over 50 percent yet lenders think that you are safely below the 36 percent threshold.

The simple advice is to not do it and accept the reality of delayed gratification. Unless it is an absolute emergency, if you cannot afford it, then you don’t need it.

But the bottom line is that ignorance is not bliss although plenty of people have used it as an excuse for getting slammed underneath enormous debt. Calculate your debt ratio before you apply for any credit and only use complete information, which means adding monthly payments from creditors that do not show up on your credit report.

You are your own most important debt manager; not your lender even if they are willing to loan you money. And use good judgment. Your debt-to-income ratio is a good tool to give you a snapshot of where you really stand with your debt.

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