There are times when you find yourself in need of a personal loan. Your financial situation may have deteriorated and your bills have accumulated to the point of needing some help. On the other hand you may feel like you want to take a loan to make a big purchase and it might be your first time seeking such assistance. There are many considerations in determining who will give you a loan and how you have to go about obtaining that loan.
How does a loan company or a bank determine if you are credit worthy enough for them to make you a loan? This is not an arbitrary process by any means. There are industry wide standards that advise a lender on whether or not you would be a good risk. The process may be the same whether you seek a new credit card with a low spending limit of say $300 or whether you are looking for a million dollar loan to purchase a new house.
This process is often referred to as a debt to income ratio. While that term is well understood within the industry it might be new to you and an explanation is in order. The term is often abbreviated as DTI.
The debt to income ratio is an example of a case where a low number beats out a high one, sort of like in the game of golf. Here are some examples of how the DTI is calculated. Hypothetically if your income is $100 and you have a debt of $15 your debt to income ratio would be 15% and that low score is considered a good indicator of your ability to pay back a new debt that you incur. Conversely if your income is still $100 and you owe a debt of $85 that is considered bad and it questions your ability to pay back anything you borrow.
Lenders believe if you can handle a low debt to income ration that you are highly likely to pay back any loan they might issue to you. Different lenders have different debt to income ratios so that if one loan vehicle is denied to you there could be another lender that will agree to give you a loan.
If the loan you are seeking is a mortgage the industry generally has an acceptable level of debt to income. That percentage is about 43%. As an example if your income is $100 and you must pay back $42 a month for previously accumulated debt, your DTI would be 42% and that would be an acceptable ratio. However, if your income is still $100 and you owe $44 a month that would make the ration 44% and that might be unacceptable to a mortgage company.
For the most part lenders highly prefer a debt to income ratio of less than 36%. Of that 36%, they prefer that no more than 28% go toward the payment of a large debt like a mortgage.
In calculating the debt to income ratio lenders do not necessarily distinguish between the types of debt you accumulate. However, lenders also take into consideration other pieces of information. This includes things like the borrowing history of the loan seeker and their credit score. If the credit score is low this can influence the lender’s decision. These days there are things you can do to help raise your personal credit score and it might pay for the potential borrower to consult an expert for ways to help increase that score before seeking a loan.
The negatives that lenders consider are equally important and if you have some of the credit issues they consider that can seriously hinder your ability to receive a personal loan. Included in these negative situations are things like late payments on your credit cards or other bills, having too many open credit card accounts, delinquencies, high balances on your credit cards and using too much of your available credit called credit utilization.
Even though you may have a few different types of loans with different interest rates that does not make a difference in the debt to income ratio. For example if you have student loan debt acquired earlier in your life and it has a certain interest rate, it makes no difference in your DTI calculation than high interest credit card debt.
While you may think of taking some additional steps to make your financial picture look better to lenders they may not make a great deal of difference. For example, if you transfer all your high interest credit card debt to new lower interest ones saving you money in the long term that essentially does not change the debt to income ratio or how much you owe and will not help you out in this case for deciding DTI.
There are some obvious ways to affect your debt to income ratio. For example, you can increase your income by getting a second job, selling some of your possessions or asking for and getting a raise. You can also lower your payments by paying off some of your credit cards. Both of those steps may go a long way to reducing your debt to income ratio.
There is another metric you may hear when you seek out a personal loan. That term is a debt to limit ratio. When seen together the difference to the borrower may be confusing. Here though is how they differ. While the debt to income ratio is determined by how much you need to pay back monthly on loans you already have, the debt to limit ratio, as mentioned above, is more o f a determinant of how much available credit you have and how much you already use.
When seeking a personal loan or a mortgage your previous credit history, credit score and debt to income ratio are all part of the numbers that go into the lender’s calculations on how much of a risk you might be. As you build your financial life these things should all go unto calculating what you do regarding debt. If you are seeking a loan we wish you well.
