MAKING SMART CHOICES
How do I know if I'm getting a good deal?
Believe it or not, that’s hard to say.
Most lenders use FICO® Scores or VantageScore® Solutions to develop lending requirements for individuals. To get a better understanding, let’s take a look at who, and what, these two organizations are.
FICO® comes from the company’s original name: Fair Isaac Corporation. FICO® takes information from each of the top three credit reporting agencies (CRAs) – Equifax, Experian and TransUnion – to calculate your score. Keep in mind, your score may be slightly different at each of the credit agencies. If it is different, that’s probably because the information those bureaus have on you differs. If your information is identical at all three, your FICO® scores from each agency should be relatively close. 1
The same three CRAs then developed their own model, which uses credit data, credit risk modeling and analytics to develop individual scores. They subsequently transferred the intellectual property rights to VantageScore® Solutions, an independently managed firm. When score differences exist at VantageScore®, it is most likely due to data differences within the three credit files.
Both FICO® and VantageScore® currently use the same credit score range: 300 – 850. These ranges generally break down into the following categories:
- 300 – 580 = very poor
- 580 – 640 = poor
- 640- 700 = fair to good
- 700 – 750 = very good
- 750 – 850 = excellent
The highs and lows of credit scores
What is the one thing to keep in mind when looking at your score? The higher your score, the less risk you pose to the lender. Lower scores indicate you’re an increased risk. And risk is what can determine the annual percentage rate (APR) on loans, fees assessed, down payment requirements and the amount you can borrow. The lower the score, the higher (or lower) these factors go. Lending requirements will become more stringent for lower scores.
Lenders don’t use just your credit score when measuring your “worthiness” as a borrower. The criteria are often complex, including whether you own or rent, your current income, other outstanding debt, credit cards and debt-to-income ratio, among others.
Unfortunately, there is no “scoring chart” consumers can check to see what rate and terms they can expect on a loan based on current credit scores. For example, suppose you fall into the “fair” range. While you can check to see what the prevailing rates are, the problem is finding out exactly what someone with fair credit can expect to get. Prevailing rates are not linked to a specific credit score range. They depend on individual lender criteria and policies, and are usually calculated in two to three seconds by decision-making technology.
Some lenders also utilize pre-qualification credit inquiries to pre-qualify customers for loan products, and to present rates and terms. If customers like the terms being offered, they can then make an application for credit and, in most cases, be approved if the necessary documentation is provided.
At a minimum, the best case scenario when looking for a loan is to know your credit score. Get pre-qualified or apply at one or two lenders whose current rates and terms you’ve researched, and preferably with whom you’ve had a prior relationship. There can be more than a one percent difference between lenders and over time, that difference can certainly add up.
How do I make sure I don’t get in over my head with debt?
One of the single best ways to stay out of debt and earn good credit is to develop a budget and stick to it. It’s also true that understanding and maintaining the right amount of debt helps as well.
To get started on the path to a debt-free and credit savvy life, here are some important tips.
Develop a budget
First thing’s first — find the program that’s best suited to you, including any of several online tools, software products or simple spread sheets. Assemble your bills from last year, and do a line-by-line accounting of how much you spent each month. Compile totals for income and expenses in categories that make sense for you.
What can be hard to track are daily expenses. If you don’t have a good record of these, start by documenting everything you spend over the next four weeks. Then use that number as your monthly cash allowance, and apply it against your income/expenses categories. If, after assembling a personalized budget, you see that you are spending more than you’re bringing in or have less than 25% left at the end of each month, it’s time to cut back.
Know your debt-to-income ratio
Debt-to-income ratio is a percentage that is determined by dividing the sum of all your monthly debt payments by your gross monthly income. As a general rule of thumb, don’t let your debt-to-income ratio be greater than 40%. And that includes any new purchase you may be considering (car, boat, home, etc.). Always remember that you need to make payments even if you lose your job or have some other unforeseen event happen that limits or eliminates your income. Plan ahead, and make sure you have at least six months’ income saved to run your household and pay all bills. Be smart about how much you borrow, when you borrow, how long you borrow for and know all of the terms and conditions of any loan.
Don’t spend more than you make
It may sound simple, but without a budget, many people don’t realize that their cash outflow is greater than their income. Knowing the amount of money coming in vs. the amount of cash flowing out in each month can help curb unnecessary spending and will help you identify which expenses are truly necessary. And don’t count anticipated bonuses or other windfalls in your budget until they actually materialize. Any number of external influences can affect income that is not set in stone.
Get more, save more
You don’t have to spend every penny you make. Instead of raising your expenses to meet your salary, bank or invest the extra funds for a rainy day. You’ll thank yourself down the road!
Make debt your friend
It’s true that debt can help build your wealth… or destroy it. To make debt your friend, here are some simple guidelines to keep in mind:
- Housing – Cap housing costs at 25% of your income. This gives you the ability to manage your other important financial obligations. Your goal should be to have the mortgage paid off by retirement. It’s crucial to avoid using home equity to incur further debt, so don’t take out a 30-year second mortgage loan after spending 15 years paying off the current one.
- Student loans – Student loan payments shouldn’t be more than 10% of your gross income. When deciding on a school, don’t borrow more than you expect to make in your first year of employment. And, if you’re paying for your child’s education, never borrow unless you can save for your retirement and still pay back the loan before you do.
- Auto loans – Generally, car payments should be in the range of five to 10% of monthly income, depending on other expenses. Loans should be for five years or less, with a 20% down payment so you don’t spend years owing more than the car is worth.
- Credit cards – This is simple. Don’t spend money that you don’t have, and pay off your balance every month. Carrying a balance on your credit cards can quickly damage your credit score.
What is a debt-to-income ratio (DTI) and why is it important?
A debt to income (DTI) ratio calculates the percent of your gross monthly income that is needed to pay your monthly loan payments. This calculation is important because it is used to determine your ability to pay back a loan. Lenders want to know that they’re not lending you more money than you can afford to pay back. Just imagine — if your constantly cash-strapped friend asked to borrow $1,000 dollars, you may think twice before loaning it to him. You may, however, feel more confident loaning it to your penny-pinching friend who pays her bills on time every month. If both of your friends got into a bind, it’s more likely your frugal friend would be able to pay you back in a timely manner. That’s how lenders see a low debt-to-income ratio. In general, less debt and higher income equals a higher likelihood of paying back a loan.
To put DTI into perspective, let’s look at an example. Sally has the following monthly loan payments:
- $700 mortgage
- $300 car loan
- $200 student loans
- $300 credit cards
This equals $1,500 in monthly debt payments. Her gross monthly income is $3,000 a month. We can calculate her DTI as follows:
Sally’s DTI would be 50% ($1,500/$3,000).
Is there an upper limit to my DTI that I shouldn’t go over?
Most mortgage lenders will not approve a loan if your DTI is over 44%. That said, it’s best to keep it at 40% or less. It’s also important to note that your gross monthly income is what you make before taxes, social security, health insurance premiums, etc. are deducted from your paycheck. Your gross monthly income does not accurately reflect the amount of money you actually have to pay your debts, household expenses, etc. each month. It’s always best to commit to payments that you can realistically pay for the entire term of the loan.
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