Picture this: You’ve put significant effort into maintaining an exceptional credit score, thinking it’s the ticket to getting a loan when needed. But when the time comes to apply, you encounter unexpected obstacles. Yes, your credit score is important, but it’s not the only piece of the puzzle. Lenders need a complete picture of your financial story. While your credit score provides insight into your money management skills, lenders want to ensure you can handle any new debts responsibly. One figure deemed vital is your debt-to-income ratio. It’s a number that many overlook, and it can make a big difference in whether you qualify for a loan.
In this article, we’ll break down loan approvals in simple terms, explaining how your credit score fits in and why your debt-to-income ratio is crucial.
The Role of Your Credit Score
Your credit score creates a financial snapshot of your money management skills. It provides lenders with a quick assessment of how well you meet your financial obligations and allows them to assign a risk level associated with lending money to you.
Lenders commonly use credit scores to price loans. The better your score, the less interest you’ll pay, and the loan becomes more affordable. To illustrate how loan pricing works in conjunction with your credit score, review the following example:
Each lender will have their own pricing tiers based on credit scores. The higher your score, the better. However, while your credit score is vital in the loan approval process, it’s not the only factor.
What’s a Debt-to-Income Ratio?
Your debt-to-income ratio illustrates how much of your current monthly income is required to cover outstanding debt. Use the following formula to calculate this figure:
Debt-to-Income Ratio = Monthly Debt Payments ÷ Gross Monthly Income x 100
Monthly debt payments include items such as your mortgage (or rent), car loans, credit cards, student loans, etc. Your gross monthly income is how much you earn monthly before taxes. Multiply this figure by 100 to create a percentage.
To demonstrate how this formula works, review the following example:
- Gross Monthly Income = $7,500
- Monthly Debt Payments = $3,000
- Mortgage = $2,000
- Car Loan = $500
- Credit Cards = $500
Debt-to-Income Ratio: $3,000 ÷ $7,500 x 100 = 40%
Why Your Debt-to-Income Ratio Matters
Your credit score provides an overall glimpse into how responsibly you manage debt. However, lenders want to ensure you can repay any new debts successfully. Your debt-to-income ratio helps lenders gauge whether a new loan will strain your existing finances.
In addition to loan payments, your monthly budget must cover other expenses, such as food, clothing, utilities, entertainment, transportation, etc. If your lender determines that debt payments will occupy too significant a portion of your monthly budget, it’s unlikely you’ll be approved for the loan. Financial institutions have a responsibility to those they serve, and they won’t put you into a situation where you’re more likely to default on a loan.
What is an Ideal Debt-to-Income Ratio?
Each financial institution will have its own policies and requirements regarding acceptable debt-to-income ratios. However, most lenders prefer this figure to be below 40%.
Use the formula and example from earlier to calculate your ratio. Or contact the credit union, and a team member will gladly help. Once you know your debt-to-income ratio, you can determine whether it’s time to apply for your new loan or whether you have some work to do first.
Strategies to Lower Your Debt-to-Income Ratio
If your debt-to-income ratio is above the 40% threshold, there are two factors to help lower the figure:
Increase Your Gross Monthly Income
There are a variety of ways to boost your monthly income. For example, you could:
- Seek out a higher-paying job.
- Ask for a raise at your current place of employment.
- Add more hours to your current workload.
- Apply for a promotion or assume more responsibility at your current job.
- Take on a part-time job or side gig temporarily.
- Include your income-earning spouse on the loan.
Decrease Your Existing Debt Levels
People are often surprised to find there are simple ways to reduce outstanding debt without significantly affecting their current budgets.
- Consolidate Debt: If you have several active credit cards, consider using a balance transfer or debt consolidation loan to reduce interest payments. Transfer your higher-interest debt to a lower-rate option, and you’ll instantly save money. That savings can then be applied to your current balance to eliminate outstanding debt quickly.
- Refinance Loans: Like debt consolidation, outstanding loans, such as car loans, are great options to refinance. Transfer the loan to the credit union to reduce your monthly payment and interest expense. Again, the savings can be applied to the outstanding balance.
- Pay Extra on Loans: Most loans today allow you to make extra principal payments without a penalty (check with your lender first). Making additional payments is a great strategy to reduce outstanding debt quickly.
A popular tactic is to round up payments. For example, if your car loan payment is $525 monthly, you might pay $600 instead. That extra $75 will be applied to the principal balance, reducing your loan balance faster.
We’re Here to Help!
Many factors determine whether a loan will be approved. Becoming pre-approved is one of the best ways to guarantee you’ll qualify for the loan and pay the least amount of interest. Our team will review your current financial situation and let you know where you stand. If your debt-to-income ratio is high or your credit score could benefit from a little boost, we’ll give insight on how to accomplish these tasks.
If you have questions about the loan approval process or would like to apply for a new loan, then we’re ready to help. Please stop by any of our convenient branch locations or call 1-800-531-8456 to speak with a team member today.
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Each individual’s financial situation is unique. We encourage you to contact United Texas Credit Union when seeking financial advice on the products and services discussed. This article is for educational purposes only; the authors assume no legal responsibility for the completeness or accuracy of the contents.