Creditworthiness, which is not solely reliant on your current income sources, is a requisite factor in order to assess your repaying capacity. Lenders look over your complete credit profile in order to determine whether or not to sign off on your application.
While you may think that your appropriate credit score dramatically increases your chances of being accepted, the fact is that the method lenders employ to calculate the risk is a far cry from that of credit reference agencies. So, what decision you will come across cannot be guaranteed to be promising at the time of applying for the loan.
It is an irrefutable fact that your credit file must be up to scratch to qualify for a loan at lower interest rates, but at the same time, you should stress other factors that exert influence on approval, such as how much you earn, a debt-to-income ratio, and a debt-to-credit ratio. The better your overall credit profile, the higher the chances of being approved. Both ratios help lenders assess your creditworthiness.
There are many factors that lenders peruse, but not all of them affect your credit rating. For instance, a debt-to-income ratio does not influence your credit score, but a debt-to-credit does. You may have come across both terms several times but might not be informed of their role in determining your credibility.
Why does a debt-to-income ratio matter?
A debt-to-income ratio reflects the total amount of debt you owe against your income. For instance, if you owe £5,000 and your total income is £10,000, the debt-to-income ratio is 50%. It is calculated by dividing the total size of debt you owe by the total income you earn. This ratio includes all kinds of debts, such as mortgage payments, small emergency loans, unsecured loans from a direct lender and credit card balances.
This ratio does not have any influence on your credit score, but lenders consider this an intrinsic factor to determine the risk involved in lending you money. It is likely that you owe a lot of money and you have been paying all your obligations on time. Even so, your lender will assume you to be a highly risky borrower. Chances are taking on a new debt will put pressure on your budget. You may end up falling behind on payments.
Apart from that, a debt-to-income ratio helps a lender decide how much money they should lend you and at what interest rate. Broadly speaking, the lower the debt-to-income ratio, the higher your chances of being approved. An ideal situation says the debt you owe should account for 30% or less. A mortgage application can also be accepted when this ratio is not more than 30%.
Some lenders may accept you even if this ratio is up to 40%, but more than that will call your credibility into question, and then your lender will either turn you down or restrict the loan amount. They will also charge high interest rates to mitigate their risks.
Ways to reduce your debt-to-income ratio
Here are the ways to help you whittle down the debt-to-income ratio:
Reduce the size of your debts
The first step in the direction of reducing a debt-to-income ratio is to increase payments towards each debt. Some loans may not allow you to pay more than set instalment amount, while others will do. But you will be charged early repayment fees. As far as it is about credit card bills, you should pay them off in fell one swoop. By clearing your credit card balances, you will see a dramatic fall in your debt-to-income ratio.
Avoid taking on debt
It is likely that you will come across some emergencies, and you may feel the necessity of borrowing money. Try not to do it because doing so will make it extremely hard to keep up with payments down the line. Your first priority should be reducing the debt rather than accumulating it.
Carefully decide whether you actually need to borrow money. Maybe you can manage without it if you cannot, and you can seek to borrow money from your friends and family. They will not charge interest rates, and this financial help is not reflected on your credit report.
Call off large purchases
When you already owe some money, try to put the brakes on large purchases. Even if you have already stashed away a considerable size of money for such purchases, put it on hold. Instead, you should utilise your savings to settle your debt. Paying them before the due date might cost you some early repayment fees, and yet you will save a lot of money in interest payments. By decreasing the size of the debt, your debt-to-income ratio will drastically decrease.
Track the ratio
Small emergency loans are convenient, and every time you come across the need for money, you do not shy away from borrowing money. This is when your debt-to-income ratio starts mushrooming. Lowering your guard can wreak havoc on your finances in the future. Therefore, you should keep tracking your ratio. Add up all your debts and divide the figure by your total income to know the exact ratio. As long as it is less than 30%, you are good to go.
Why does a debt-to-credit ratio matter?
Your debt-to-credit ratio indicates the amount of revolving credit you owe against the total amount of credit limit available to you. In other words, this ratio is known as a credit utilisation ratio. Since it only includes revolving credit, mortgage payments and other instalment debts are not included in the calculation. It only includes credit cards and a line of credit. Unlike mortgages and other instalment loans, credit cards and a line of credit are not closed after paying off the balance. You are eligible to withdraw funds again.
A debt-to-credit ratio is ideally recommended at 25%. On no account should it be more than 30%. For instance, suppose you have two credit cards, and their combined credit limit is £10,000, and you owe £3,000 on one card and £2,000 on another. Then, the combined credit you owe is £5,000, which is half the total limit. Therefore, your credit utilisation ratio will be 50%. It is outrageously high. Lenders will be sceptical about your repaying capacity for any new loan.
Not only will your credibility be brought into question, but a high debt-to-credit ratio will also pull your credit points. Lenders suspect borrowers with high credit utilisation ratios as default borrowers. They might conclude that you, more often than not, rely on credit to get along. Consequently, not only will you be restricted from borrowing a larger sum, but you will also be charged very high interest rates. There is the likelihood of being turned down, too.
The key difference between debt-to-income and debt-to-credit ratio
Your debt-to-credit ratio highlights the total amount of balance you owe against the revolving credit limit, which influences your credit scoring. However, this is just the one factor that determines your credit rating. Other factors include payment history, a credit mix, credit history length, and the like.
On the other hand, your debt-to-income ratio throws light on the total amount of debt you owe against your income. Though it does not affect your credit rating, it is an important factor to check your creditworthiness. A high ratio may result in the rejection of your application.
The bottom line
The concluding statement is that both debt-to-income and debt-to-credit ratios are crucial, and they both affect your borrowing capacity in different ways. You should aim to keep these ratios as low as possible. The lower the ratio, the higher the chances of being approved.
However, bear in mind there are also several other factors that affect your credibility and credit score. Focus on those factors, too. To qualify for a loan at a lower interest rate, you should try to keep your overall credit profile good.
