A few months ago I applied for a car loan and got promptly roasted by the credit union’s loan underwriter. My credit score is strong, so I wasn’t sure what happened.
“Your debt-to-income ratio is outside of our guidelines,” she told me.
Oh, snap. I think it was her way of politely saying that I earned jack shit, because my only debt is a student loan under income-based repayment and my rent. That’s it.
Just how is the debt-to-income (DTI) ratio calculated anyway?
In simple terms, your debt-to-income ratio(DTI) is the percentage of your income that goes to repay debts such as credit cards, student loans, existing car loan payments, and your rent or mortgage payment. Lending institutions such as banks, credit unions, and finance companies watch this figure closely and it plays a big part in whether or not your application gets approved.
Crunch those numbers
Let’s suppose you rent a room and your rent payment is $600.00 a month. You have a minimum credit card payment of $30.00, along with a student loan payment of $50.00 per month under an income-based repayment plan.
Total debt: $680.00 per month.
Your income before taxes: $1900.00 per month.
$680.00/$1900.00= 36% of your income goes to repayment of existing debt. In most cases, that would put your application in either the “no” queue or the “secondary financing” queue for higher-risk borrowers.
Depending on the loan approval guidelines for a given lender, you may still get your loan approved if you have a high credit score, a co-signer, or you’ve been at your current job for a few years. Lenders refer to these factors as “compensating factors” that can offset a less-than-ideal DTI ratio in some cases.
Generally speaking, the lower your DTI ratio and the stronger your credit score, the better chance you have for getting your loan approved by a first-rate lender (trust me. You’ll want a first-rate lender for many reasons).
If your overall debt load is 36% or higher, the lender will view you as a higher risk of default and you may get stuck with a higher interest rate, a larger downpayment requirement, or end up getting financed through some backwoods finance company that will make your life hell.
Fun with numbers
If you want to find out where you’ll really land on the DTI spectrum, factor in your proposed car payment along with your existing installment debt. After all, the lender will do the same thing when determining whether or not you qualify for that low interest rate.
When calculating your DTI ratio, only include installment debt such as student loans, existing car payments, credit card payments. Don’t include utilities or your cell phone bill.
By knowing your DTI ratio in advance, you’ll have a better idea as to how much you can afford to pay without giving a lender (or yourself) a heart attack, and your chances of qualifying for a decent interest rate and quite possibly the car of your dreams.
If your DTI too high, in the 40 percent range for example, it’s best to put off the car purchase until you can lighten your debt load. If you’re screwed and really need a car, prepare yourself for a higher interest rate and/or a limited selection of vehicles, and for dealing with a less-than stellar finance company.
Although your credit score plays a significant role in determining your eligibility for a car loan, your DTI can either help you or hurt you when it comes to getting a good interest rate with a reputable lender and the best shot at getting the vehicle you really want.