You probably think your credit score is the main thing that lenders and creditors use to decide whether to give you a loan. But they use other tools to measure your creditworthiness and whether you’ll have a tough time repaying a new debt.
Keeping your credit in top shape involves more than making your payments each month. Even if you make minimum required payments, your credit score may not be optimal.
Definition of ‘Credit’
Credit is a contractual agreement in which a borrower receives something of value now (usually money) and agrees to repay the lender at some date in the future, generally with interest.1
What do Lenders Look at to Make a Loan?
Lenders look at things like your debt-to-income ratio (DTI), credit utilization, and total amount of debt on your credit profile.
Lenders use the DTI ratio to see if you have enough income available to pay your debts. You know you are suffering from a high debt-to-income ratio if, once you pay your fixed expenses (like housing, other loans, and utilities), there is very little left over at the end of each month. The higher the DTI, the less likely you will be able to repay the requested loan and so the less likely you will be approved.
How much of your available credit do you actually use? Do you borrow the maximum on your credit cards each month? A high credit utilization rate will negatively impact your credit score.
Total Amount of Debt
If the total volume of debt on your credit profile is too high, you can be denied credit even if you’ve got a good history of making debt payments. You might be making the minimum payments on all that debt, but paying off your debt in full could take decades. In short, you could use some help with your credit card debt.
A Good Credit Profile
What does a good credit profile look like? A profile capable of taking on a loan has a low debt-to-income ratio, has credit utilization rates under 30%, and carries very little debt. A good credit profile also shows some savings, whether in the form of savings accounts, retirement plans, stocks and bonds, or some other liquid asset. And of course, that profile will have an excellent history of making payments to lenders and creditors on time every month.
The trick to understanding your credit worthiness is to remember that all of these components are interdependent. High credit utilization rates hurt your credit score. A high debt-to-income ratio prevents you from having the money left over each month to pay down new debt . High total debt amounts drive up the minimum payments you need to make, and most of those payment will only cover interest without significantly lowering the principal you owe.
This credit trap could keep you in debt (even if you stopped using credit cards today) for the next 14 to 27 years. For the vast majority of that time you will not have the ability to get new credit because you will not have the capacity to pay it back. So even making on-time payments every month won’t help your credit worthiness or your financial future.
If you need help with your credit card debt, and want to learn how to save money, get in touch with one of our consultants at 1-800-495-4069.
1 Investopedia.com, 2014