Almost everyone has heard of credit checks and many keep a regular watch on their personal credit score.
Having a ‘poor’ credit score can ultimately lead to more expense, for example, a credit card for bad credit will have a low limit, carry a very high rate of interest and have severe penalties for late payment or exceeding the limit.
So it is important to consider these factors when looking at taking on one of these cards.
A ‘Debt to Income Ratio’ (DTI) is a measure that compares income against certain monies owed and, although not widely known, it is something that is often used in conjunction with credit scoring.
It is used mainly by mortgage lenders to establish financial suitability for the purchase of a property, but it also provides a useful tool for anyone to keep a check on their overall financial viability.
To complete the calculation, it is first necessary to list and total all monthly commitments or debts. This should include mortgage or rent payments, loan repayments (secured and unsecured), minimum payments for credit and store cards, bank charges (for overdraft), insurances, child maintenance and student loan payments.
Next, all monthly income should be listed and totalled. This will include basic salary or wages, commission, overtime, bonuses, tax credits, state benefits, child maintenance, pensions and any other documented income.
The debt to income ratio is then calculated by dividing the total of monthly debt repayments by the total monthly income.
As an example, the figure derived could be 0.40 which would be considered a ratio score of 40. The optimum is a ratio score of 36 or less, the lower the better.
When a DTI calculation is used by mortgage lenders, they use a standard which is known in the industry as the ’28/36 rule’ to determine if the borrower can realistically afford the proposed repayments.
The rule states that households should spend no more than 28% of their total gross income on housing costs, which are known as PITI (Principle, Interest, Taxes and Insurances) and a maximum of 36% on total repayments and debts.
With any higher score, the mortgage could potentially be declined unless a larger deposit could be paid.
A good reason for an individual to keep track of their personal DTI score is because any score higher than 36 is a cause for concern, indicating poor management of credit.
Other than the obvious pitfall of not obtaining a mortgage at all, other effects can be an inability to obtain credit of any type without paying exorbitant interest rates, a credit card for bad credit risks being a classic example of this.
In today’s harsh financial climate, it certainly pays to be aware and in control of personal finances. By regularly checking both their credit rating and debt to income ratio, an individual has far more chance of spotting downward trends in their financial position and of being able to take appropriate action.
It is important to resolve these issues before the situation becomes serious enough to affect future credit decisions in a negative way.
Guest Post from MoneySupermarket
