Understanding why lenders don’t like high debt balances means understanding borrowing money. Borrowing money is an agreement: a bank or creditor agrees to loan you money on a predetermined repayment plan. The creditor’s decision to lend you money is usually based on an item you own that becomes collateral (secured debt, such as your house or your car) or based on your income (unsecured debt, like a credit card).
You get the benefit of owning items you haven’t yet paid for. The lenders, on the other side of the transaction, earn interest (and fees) on the money they lend, and so make a profit. The lender is also taking on a certain amount of risk — the risk being that the borrower will fail to pay back the debt.
So when lenders are evaluating whom to loan money to, they definitely spend a lot of time evaluating debt you are already carrying. That debt represents greater risk for the lender: the more debt you have, the higher the risk you would not pay back the loan they are lending you. Let’s take a look at what they see:
Qualifying for a Loan Comes From More Than 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.
This is why lenders generally seek additional information before deciding on a loan application. They will look into the following key features of your financial stability: income, savings account balances, job stability and debt-to-income ratios.
That last one — debt-to-income ratio — is a loan underwriters’ greatest concern, according to a FICO survey for the Professional Risk Managers International Association.
Why High Debt Balances Matter So Much
They Create the Debt-to-Income Ratio:
Simply put, debt-to-income ratio (DTI) is the percentage of a person’s monthly gross income that goes toward paying debts. There are different considerations for secured debts (mortgages and car loans, for example) and unsecured debts, which is generally credit card debt. Secured debt is tied to an actual asset that can be liquidated, so it is considered “good” debt. Credit card debt, on the other hand, is high-risk debt. If a large percentage of your income is going toward managing that credit card debt, that can throw a red flag to a loan officer.
Unless you are applying for a debt consolidation loan, which can be a good option for people struggling with high-interest credit card debt, says Mike Donnelly of the Funding Hawk firm, which provides debt consolidation loans to consumers. The goal of a debt consolidation loan is to lower your interest-rate burden on your existing debt, essentially trading high-interest credit card debt for a lower interest loan, which you use to pay off all the credit cards.
Different loan types, however, have different maximum DTI limits. For example, an underwriter on a home loan might look for a DTI under 43%, considering the new loan payment and all monthly debt obligations.
For example, if you earn $6,000 a month before taxes and your debt to income ratio is 46%, you are paying $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.
Debt Balances Also Come With Report Cards:
How you manage the debt you are currently carrying is included in your credit report. Credit blemishes such as late payments or loan defaults will have the highest impact on your credit score for the first 12 months. Then, over time, the impact on your score will drop.
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. And maxed out credit cards can indicate financial trouble. If you find yourself struggling with your own credit card payments in this way, now might be the time to consider a debt consolidation loan.
Credit Utilization Ratio is Also a Factor:
Credit utilization is another measure loan officers use to judge your likelihood of paying back your debts in a timely manner. A high credit utilization ratio — meaning you are using most of your available credit — means you have less wiggle room in your monthly budget. It also means you likely have almost no financial resilience. If you have a sudden expense like a health emergency, you don’t have any credit to apply to the situation.
The preferred credit utilization rate, according to FICO, is 30 percent. So if you have $10,000 available credit on your credit cards, you would use no more than $3,000.
If you are close to maxed out on your credit cards, you should consider making some changes. The best change would be to make a firm plan to pay down or resolve your debt. A solid financial goal for everyone is to be debt-free — at least from high-cost unsecured debt.