What Your Credit Score Doesn't Tell You, And How To Improve Your Creditworthiness

 

What Your Credit Score Doesn't Tell You, And How To Improve Your CreditworthinessWhat do lenders look at when determining your creditworthiness for a mortgage?

Without a doubt, the first thing that came to your mind is your Credit Score. This is what everyone talks about, and at the same time, very few people do understand how this score is determined. However, there is another number, which is rarely communicated to you by lenders, and that is being used by mortgage companies and banks as the major determining factor for your creditworthiness - Your debt-to-income ratio (DTI). Here’s what it is and why it’s so important.

DTI - Explained

Your debt to income ratio (DTI), sometimes also referred to as debt burden ratio (DBR) in certain countries, is what lenders compute to determine your creditworthiness. In countries where credit score is not available, your DTI may be the main measure of your creditworthiness for a loan, refinancing, or credit. The debt to income ratio is exactly what it sounds like: the amount of debt you owe as compared to your overall income. 

Your lenders will look at this ratio when they are trying to decide whether to lend you money or extend credit. A low DTI means you have a good balance between debt and income. As you might have guessed, lenders like this number to be on the low side, which means your debt is at a manageable level relative to your income. The lower it is, the greater the chance you will be able to get the loans or credit you seek.

Total debt is the total of all your monthly debt obligations, which are considered monthly recurring debt. It includes your home mortgage or rent, car loans, student loans, your minimum monthly payments on any credit card debt, line of credit, and any other loans that you might have.

Your lender seeks to assess how comfortable you are with paying both your current debt as well as your ability to borrow more. For that reason, your new monthly mortgage payment (towards the new loan you will be applying for) will be added to your total debt computation.

Gross income is the sum of all your earned income (from your job) and unearned income (passive income) before tax. In the case of unearned income considerations, careful and responsible lenders need to account for a cushion in the event of any month you do not receive this unearned income from rentals, businesses, or paper assets. Those lenders are often conservative and assume about 80% of unearned income. Inquire with your lender about their current practice on this topic.

DTI, expressed in percentage, is computed by dividing your total debt over gross income. By definition, it is a calculation of your total gross monthly debt or payments divided by your total gross monthly income. This percentage helps lenders determine the kind of borrower you’ll be. The smaller the percentage, the better.

DTI Traffic Light - Approved or Rejected?

Even if you pay your bills on time, have a solid income, and carry a good credit score, the ratio of your monthly expenses and debt requirements to your income is central in the mortgage approval process. When lenders compute your debt-to-income ratio, there are three major thresholds they follow.

35% or less - Green light: You are looking good, and your lender will favor your application. Compared to your income, your debt is at a manageable level. You most likely have money left over for saving or spending after you’ve paid your obligations. 36% to 49% - Yellow light: You are still eligible for a loan, but you have an opportunity to improve your situation. You’re managing your debt adequately, but you may want to consider lowering your DTI. This could put you in a better position to handle unforeseen expenses. Your lender may ask you for additional eligibility criteria. 50% or more - Red light: You need to take action to get your finances in order. In the eyes of your lenders, you may have limited funds to save or spend. With more than half your income going toward debt payments, you may not have much money left to save, spend, or handle unforeseen expenses. With this DTI ratio, lenders may limit your borrowing options or even categorize you as not eligible for loans.

Determining the Maximum Mortgage Loan You are Eligible For

From a lender's perspective, loan eligibility is based on your debt-to-income ratio. As shared above, your lender will allow a maximum DTI of up to 50% of your gross income, and this includes all your loan obligations, including the mortgage installment being considered by your bank.

Below are the steps followed by a lender in computing the maximum loan amount you will be eligible for:

Compute your maximum allowed debt obligation by multiplying your current gross income by the DTI ratio set by your lender. This allows your lender to determine the sum of total monthly debt you will be comfortable with affording on a recurring monthly basis based on your income. Compute your maximum monthly mortgage loan installment , which includes the new loan installment. This is computed by subtracting your existing total monthly debt from your maximum allowed debt obligation. Compute your maximum monthly mortgage installment related to principal and interest . Your maximum monthly mortgage loan installment (step 2 above) covers all four components of a mortgage: principal, interest, taxes, and insurance (often referred to as PITI). Installments towards both the principal (P) and interest (I) apply directly to settle your loan with your lender on a monthly basis throughout the terms of the loan. On the other hand, payments towards property tax (T) and home insurance (I) are obligations you owe to the government and your home insurance provider and therefore are not counted towards settling your loan. Compute the mortgage value you are eligible for . Both PI components of the monthly loan installments, when paid throughout the terms of the loan, will settle the full mortgage loan by its maturity date. So, adding those PI monthly installments over the total number of months throughout the term of the loan will determine the total amount you will be paying throughout the same period. This amount includes both the total principal amount (which is mortgage value) and total interest paid. This suggests that by subtracting the total interest from the total payments throughout the term of the mortgage, the principal value (which is the mortgage value) can be computed.When you want to invest in income-producing assets (such as real estate), you will need funds to finance your purchases. Determining your loan eligibility allows you to figure out the starting capital that will be borrowed.
I have provided a mortgage loan eligibility calculator that does all the computations explained above.  It can be downloaded from the link below.
Related: Free Loan Eligibility Calculator

Strategies to Improve Your DTIWhen you apply for a mortgage and your loan gets rejected due to your high FTI, it’s not the end of the world. You can lower your DTI by:
Paying off debt: TThe more monthly debt payments you can eliminate, the lower your DTI will become. It will be a wise move to pay off first those high-interest loans with the high monthly installments. If your finances can handle it, pay off early those revolving loans (such as credit card loans and lines of credit) and get rid of these monthly payments once and for all! Restructuring your debt: This strategy, if well executed, will boost your DTI to acceptable levels in no time. I encourage you to discuss this strategy with a professional who can guide you on consolidating all your revolving loans and short-term loans into longer-term loans. This will definitely reduce your total monthly debt obligations to a level that reduced your DTI. Increasing your total income:  Increasing your earned income (salary) doesn’t happen with the snap of your fingers, but have you considered creating a stream of passive income that will increase your total income?If possible, adding a co-borrower or co-signer to the loan who has a lower DTI than yours might bring your combined DTI down to an acceptable level.If you’d still like to know more, get in touch with us, and let's discuss the strategies that are possible to you.
Related: Book a Discovery and Strategy Call to Discuss Your DTI