Not just your credit score

           This post is a bit longer than my typical post but I think that you will find it helpful.  This post describes in some detail the inner workings of the credit decision made by lenders.  So if you are trying to borrow money for any reason or you think that you might consider buying something on credit in the future then you may find this post helpful.  As always keep in mind that every situation is different and I can not offer legal advice over this blog.  Make sure you seek out the information you need before making an major financial decision. 

 There are three categories of information that are relevant to an individuals credit worthiness.  The first category deals primarily with the repayment of past debts.  This is reflected in your credit score.  The second category deals with your income and the third with you current liabilities.  (ie how much money you owe). 

            It’s the balance between these three things that make up the true picture of your individual creditworthiness.  When a lender evaluates a person’s credit they do look at the score, but they also look at the debt to income ratio. 

Debt to Income Ratio = Total Debt/ Total Income

            The lower the product of this formula, the better your overall financial position is.  For example if you owe $1000 and make $100,000 dollars a year then your debt to income ratio would be calculated in the following manner. 

Example #1: Debt to Income Ratio = $1000/$100000 = .01

          This means that for this individual their total debt is 1/100^th of their gross annual income or more clearly stated their gross annual income is 100 times their total debt load.  A very manageable number regardless of how much debt or income a person has.  It wouldn’t matter if the person had one million dollars in debt if their ratio was still .01 then they could easily afford to pay their debt.  Of course to keep that ratio they would have to be making one hundred million dollars a year. 

Example #2: Debt to Income Ratio = $50,000/$100000 = .5

            In Example # 2 the person’s income remained $100,000 a very respectable income, but their total debt increased to $50,000, which caused their debt to income ratio to rise to .5.  Even at this level, they probably can afford to pay their debts but as you can see the higher the ratio the more difficult it becomes to pay one debts. 

            Now that we have seen how this ratio is calculated and understand why it’s important we can see why it is that lenders want the information that they require.  Interestingly, while filing Bankruptcy hurts your credit score (which is calculated primarily on past repayment of debt), it significantly improves your debt to income ratio, arguably making you a much better credit risk after Bankruptcy. 

Let’s take a look at a more typical example, where the individual considering Bankruptcy has a car that they owe $15,000 on and $50,000 dollars in credit card debt.  In this scenario let’s assume an income of $40,000 per year

EXAMPLE # 3: Debt to Income Ratio = $65,000/$40000 = 1.63

            As you can see, this person is probably struggling to make their payments with a ratio significantly above one.  Let’s assume that they chose to keep their car when they file Bankruptcy.  Which means that post Bankruptcy, this individual will owe $15,000 on their car and will have no credit card debt.  The Bankruptcy should not affect their income. 

EXAMPLE #3 After BK: Debt to Income Ratio = $15,000/$40000 = .38

          As you should be able to see the Bankruptcy process greatly improves their debt to income ratio making them a much better credit risk.  Many banks and lenders who understand this trend are quite willing to extend credit to individuals shortly after they file Bankruptcy. 

            When excluding your home it is a very good idea to keep your debt to income ratio as low as possible.  For a variety of reasons the numbers are a little different when a home mortgage is involved, which is why I recommend calculating your debt to income ratio both with and without your mortgage included.

            Example #4 illustrates the impact of a home mortgage on this calculation.  In this scenario, the individual has a home mortgage of $150,000, credit card debt of $15,000 and income of $50,000 a year. 

I go in to these issues in much more detail in my book which you can buy on amazon by clicking the link to it below.