Borrowing money allows you to leverage income. You can buy things today without having the cash to complete the purchase. Lenders, on the other side of the transaction, want to earn interest (and fees) on the money they lend, to make a profit. When extending a loan, they also run the risk of a borrower failing to pay back the debt.
Even if you have the cash on hand to make a large purchase, when it comes to borrowing money, higher debt balances scare lenders. Here’s why:
Loan Officers Look at More than Just Your Credit Score
Credit scores are readily available to both consumers and lenders, offering a snapshot of your debt repayment history. Businesses want to know your score when you apply for new debt, register a utility in your name, finance a cell phone, rent an apartment, and even apply for some jobs. However, your credit score tells a lender or business very little about your financial aptitude.
Due to its limitations, lenders often seek additional information before deciding on a loan application. Loan officers also care about the high debt-to-income ratios, job stability, income, and savings account balances.
The Professional Risk Manager’ International Association, PRMIA, conducted a survey for FICO asking lenders their highest concern during the underwriting process. 59% of the lenders agreed that high debt to income was their top concern when approving loans. Only 13% cited several recent credit applications, and 10% expressed concern over an applicant’s low FICO score.
While that all-important three-digit number factors into credit decisions, your score alone is not the only clue to how you manage debt.
What a Credit Report Says About You
Companies such as FICO and Vantage create credit scores based on data found in your credit report. The credit score represents a mathematical calculation, where the credit file contains the data, which makes up the score. Much like looking at a final grade in a class versus reviewing each assignment and test to determine how the professor came up with the grade.
The score might indicate whether you are currently paying bills on time, but does not determine how much you can responsibly borrow or the ability to repay new debt.
Your credit report contains identifying credentials such as name, social security number, job and residence histories. It lays out a month by month record of payments. The report tracks credit limits, current balances, the minimum payment due each month, and the most recent payment made for each account, along with a two-year record of credit applications.
Credit reports also reveal data from public records, which can include bankruptcy, foreclosure, tax lien, repossession, or civil judgment.
Why Debt Balances Matter So Much
Creates the Debt to Income Ratio: Lenders use the data found in the report to determine current monthly debt payments and debt balances. When compared to income, they can establish the debt to income ratio used for loan decisions.
Different loan types have a different maximum debt to income limits. For example, an underwriter on a home loan might look for a debt to income under 43%, considering the new loan payment and all monthly debt obligations. Underwriters include student loans, car payments, credit cards, and other loans documented in the credit file. Their determination will establish the maximum loan you can receive when buying a home.
For example, if you earn $6,000 a month before taxes and your debt to income ratio is 46%, you pay $2,760 towards the mortgage and other debt obligations each month. Paying a tax rate of 30% (including taxes, social security and Medicare payments) would leave you with a little over $1,000 a month to pay for all other expenses.
Monthly costs not included in the debt to income ratio include utilities, insurance payments, transportation, food, entertainment, extracurricular activities, and emergency expenses. The calculation also leaves out money for savings, retirement investments, and other financial priorities.
Treatment of Credit Blemishes: Derogatory activity typically remains on your credit file for seven years, with a bankruptcy staying on the report for ten. A credit blemish such as a late payment or loan default will have the highest impact on your score the first 12 months. The further the infraction was in the past, the less it impacts the score.
Lenders look for patterns in defaults. Did they all happen over a short span of time? If so, an explanation might overcome the negative data. When late payments occur randomly and consistently, it shows a more troubled history of debt management.
Credit blemishes will not automatically lead to a loan decline. Lenders often overlook seasoned late payments and even major infractions such as a foreclosure or repossession after three or four years.
Current Financial State: High current balances reflect a more immediate credit challenge, rather than an event in your past. Debt is either a loan or line of credit. A loan has a fixed payment over a specific time frame. For instance, a car loan might last for six years with a $400 monthly payment.
A line of credit, like a credit card, you use, payoff, and re-use at will. Because of the flexibility of credit cards, they better represent credit management skills. You can make very low minimum payments for years on a credit card or carry no balance and pay no interest. Maxed out credit cards can indicate financial trouble.
Larger Effect on The Credit Score: Recently, the Vantage credit score began putting more weight on balance trends rather than a static look at revolving balances. Borrowers with increasing balances receive a lower score than borrowers with declining balances. Vantage believes trends provide a more accurate indication of financial health, than balances alone.
Utilization ratio is the balance to credit limit ratio on revolving debt, such as credit cards. FICO tracks 30% of a credit score through the utilization ratio, making it a major factor in your overall credit rating.
High debt balances can have a higher weight than older late payments because it is a clearer indication of your current financial state. Lenders want to understand your overall financial profile when determining whether to approve or decline a loan and what terms they will offer.