Personal Finance presentation five C’s of credit capacity prepared to get financially fit by practicing personal finance. First, we’re going to take a step back looking at the five C’s of credit, which is useful if we want to get a loan at this point in time or in the future, five C’s being general categories that will be looked at to see whether or not you will be approved for a loan. In most cases, by most institutions. It’s also just a good indicator of how healthy your credit currently is.
So the five C’s then include credit history, something we took a look at last time in a prior presentation capacity. That’s the one we’re focusing in on this time. In future presentations, we’ll look at the other C’s including collateral capital and conditions. So we’re focusing in on capacity, one of the factors to see our credit health, the factors that institutions will often be looking at. So we have capacity is an indicator of the probability that you’ll consistently be able to make payments on a new credit account.
So obviously, if you are a lender and you’re thinking about giving someone a loan, one of the major things that you want to look at is to say, hey, do we think that you’ll be able to make the payments, if you look at the past history, we could say, hey, look, they have a good credit record, possibly, of making payments in the past.
But we also want to see how likely they’ll be able to make the payments and given their current income situations with regard to their income and their current obligations. So lenders use different factors to determine your ability to repay, including reviewing your monthly income and comparing it to your financial obligations. So we’re basically thinking about kind of an income type of situation, oftentimes breaking it down into a monthly situation, just try to see how likely you’re going to be able to make a payment on a new type of monthly payment.
Most likely, if it’s an installment type of loan, that you could be taking on if you were to take on another debt, another loan, resulting in another payment. This calculation is referred to as your debt to income, the dti ratio, which is the percentage of your monthly income that goes towards expenses like rent, and loan or credit card payments. Now notice we call it debt to income. And there’s different kinds of calculations that different institutions might use for a debt to income calculation.
So note, when we’re looking at these kind of statistical calculations, on the individual side of things, they’re often not as standardized. If we were to take a look at these kinds of ratios for say, corporate finance, or corporations on the corporate side of things. And therefore, when you go to different institutions, they might use slightly different types of calculations.
And when you are doing the calculations yourself, just to determine your own financial health, you might use different kinds of ratios as well. So remember, when you’re doing ratio type of analysis, it’s really important, because if you just look at the dollar differences that come up, then you’re not going to be able to compare that as easily with prior performance where possibly you had different dollar amounts involved as easily as you can with percentages.
And you cannot compare them as easily with other people that that have different dollar amounts. If I’m trying to compare my habit or my, you know, debt, or my capacity type of calculations to other people who possibly are doing better because I’m trying to benchmark towards them, they might be having more income. Therefore, I can’t just compare the dollar amounts, I have to do the ratios.
But in order to compare ratios, I got to make sure that I’m picking up the same kind of ratios, in the same numbers, the same format, that they are in the same percentages so that we can then have comparable numbers. Now, if you’re doing this for an institution, then you have different objectives. If your objective is to get a loan, then you’re trying to look as good as possible without lying, right, you’re trying to look as good as as possible, giving them the information they need to look as good as possible within the conditions of you know, the financial institution.
So in that sense, when you put the debt to income ratio, you’re putting it in place in whatever way that whatever institution is asking you to do so, so that you make sure that you’re accurate with it. And you’re trying to put it in such a way that you’re you’re viewed in the best light, because obviously your goal is to be accepted for, you know, for financing, and that kind of situation.
So why capacity matters. Lenders look at your debt to income, the dti ratio when they’re evaluating your credit application to assess whether you’re able to take on a new debt. A low dti ratio is a good indicator that you have enough income to meet your current monthly obligations, take care of additional or unexpected expenses and make the additional payment each month on the new credit account. So when you’re looking at this with regards to a financial institution, you want it to be lower because we’re looking at basically the debt which is going to be the payment
You know the amount that we’re going to be paying for, in essence, debt versus the income. So the debts on the numerator or the payments that you’re making for debt related type of things, and the income is on the denominator. So that would mean that you obviously, you’d want the debt to be lower with relation to the income. So you’re going to want this this ratio to be lower, the lower the better on the ratio when you’re looking to get financing generally from the bank, the lower the better in that instance. So calculate debt to income.
So how do we actually put this thing together? So your debt to income ratio, the dti compares how much you owe each month to how much you earn. Specifically, it’s the percentage of your gross monthly income before taxes. Now, this is the first kind of component that gets a little confusing. Now we’re actually into the calculations of this, we do have some example problems. So you can take a look at those for a little bit more detail. But note, the first thing, if you’re looking at a financial institution is to say, Well, are you talking about gross income?
Or are you talking about my net income after withholdings, taxes after taxes have been taken out, so they’re saying before taxes, right, and this calculation, now, if you were doing this for your own purposes, you might use the net income if you want to compare it, and if you thought it was a better comparison, if you’re doing this for a financial institution, you want to make sure that you’re following whatever, whatever the rules that they have given you.
And if they haven’t given you very specific rules you’re trying to do, you’re trying to look good, right, which means you’re trying to make the ratio look lower, in this case, as long as you’re doing so within the guidelines that have been provided for you. So this time, they’re saying gross monthly, that doesn’t mean it’s the amount that’s actually going to be hitting your bank account, because the bank account will be after the withholdings, meaning, you’re going to have your income minus they take out at least the federal taxes, which is federal income tax, Social Security and Medicare and possibly other benefits before it hits your bank account.
So make sure then in this instance, you’d want to be taking it from your pay stub, which would have the full gross wages before the withholding pay stubs are required to be given to two people. And therefore you should have access to your pay stub from your employer, if you are a W two employee somewhere. So that goes towards your payment form. Then the things that payments are for things like rent, mortgage, credit cards and other debt.
Now this is the other one that gets kind of confusing, because the debt side of things, the top side of this calculation is the amount of payments that are going for debt compared to your to your income amount. Now, you would think that the amount of things going towards debt would be loans, some kind of loans, but it they’re including some things or some institutions might include some things which are commitments, but not exactly loans.
So in other words, a mortgage is clearly your payment that you’re paying on a mortgage is clearly a debt type thing, because it’s a loan, and you’re paying you’re, you’re you’ve committed to these payments for the loan, and you can break that down to a monthly payment, the credit cards is in essence alone as well. So that makes sense, although the credit cards are a little bit tricky, because you can ask, Well, how much do you want me to put there because I could pay the whole thing off, or I could go as low as minimum payments.
Now, oftentimes, financial institutions will ask for the minimum payment, because they know that when you’re trying to look good, you’re probably going to if you if they gave you a choice, you would try to use the minimum payment. And anyways, because that would lower the ratio. So they’re going to basically say it’s the minimum payment, if you were doing this on your own for your own financial health, you might, you might do something different than that.
So again, it depends on what your kind of purpose is, and how you’re doing the comparisons as to what your ratio is going to be. But also note they put in the rent here. So if you don’t have a home, and you’re renting, then you’re paying monthly payments, which you’re pretty much locked into. But it’s not exactly debt in that case, right? Because the rent is not alone. You’re paying rent as you use, you know, as you use the place. So it’s not exactly the same thing.
But you can see why financial institutions would want to pick that in there because they’re putting things in there which are fixed, which I guess in essence, you don’t have control over. Notice what’s not in there are other expenses, like groceries or something like that. Because those are clearly not, you know, debt related things, you have a lot of flexibility with those. So once again, you know, this gets a little bit confusing in terms of what kind of things you’re going to be adding to basically the debt type of payments within the ratio and you got to know what those things are.
So you can do relevant comparisons if you’re comparing with other people in terms of the ratio or to the past in your own books, making sure you have the same comparisons being used in the past and the present and or with the financial institution to meet to meet the goals that you’re going for with the financial institution. So calculate debt to income.
So what you do is you’re going to add up your monthly bills, which may include now notice it says bills here because and that’s a little deceiving because again, it says it’s usually debt, your debt payments, when it says debt, you might may shorten the calculation. So they can put this nice little acronym dti. But it’s not it’s not really debt, meaning it’s not your liability, you’re not, you’re not picking up your mortgage balance, like $100,000 mortgage balance for whatever you’re making, you’re picking up the payments on the debt.
So its debt payments really, compared to your income ratios. And then they kind of tweaked it a little bit, they tweaked a little bit in some in some places, tweaked it to try to pick up expenses that are that are basically fixed expenses that you don’t have control over. So in this instance, we’re picking up here monthly rent. So again, rent is kind of like an expense, but it’s basically a fixed expense, or the house payment, which would be like a mortgage, which is clearly debt, monthly alimony or child support.
So again, that’s not really debt. But it’s a monthly payment that you’re committed to or there’s so you’re kind of locked into it. So it’s not like a loan payment. But it’s, it’s still still there, including that which is a little funny with a debt to income. But you can see why that would be because they’re trying to have those fixed payment, then student that is a loan, a student loan, that makes sense as debt, auto loan would make sense. Other monthly loan payments, obviously, any loan payment would be generally debt, and then they have credit card monthly payments.
And they say specifically, and these instructions are saying, use the minimum payment. So that’s another question you could have, because obviously, if you’re paying off the credit card, you can pay off whatever however much you want. So what do you want me to add on the credit cards, they’re probably they’re gonna use the minimum payments, oftentimes at an institution, because they probably figure and you’re going to try to pick the minimum payment anyways.
Because if you’re trying to get a loan, you’re trying to look as good as possible, which means you’re trying to lower the debt payments as low as you can without, you know, violating the rules of whatever, whatever the rules are, for you put the calculation together. So then you divide the total by your gross monthly income, which is your income, before taxes. So if you’re a W two employee, that the gross income would basically you want to make sure that pick that up from your pay stub. And like if you’re doing this for a financial institution, that’s really important, because it’s a big difference.
You want to pick up the bigger number, if you can, and the bigger number would be the number. That’s the gross income, not the amount that hits your bank account, which is net income after they took out because the amount to hit your bank account, they already took out the taxes for the withholdings, Social Security, Medicare, federal income tax, and so on. So what debt to income ratio means what does it mean? Well, 35% or less means you’re going to be looking good. And these are just general kind of categories. So if you’re if you’re under like 35%.
Now, this is important for financial institutions, if you’re looking for a loan and just to measure your own financial health, meaning if you’re below 35%, you might be you know, in a range where you can feel fairly comfortable out relative relative to your income, your debt is at a manageable level generally there and you most likely have money left over for savings and spending after you’ve paid your bills. Lenders generally view a lower dti as favorable.
So obviously the lenders want a lower dti. So anything you know if it was under 35 would be better, even still. But if it’s 235, you might feel fairly healthy. And you can check that you can do your own dti ratio, and then see, does that make sense to you? If you’re below 35%? Do you feel comfortable that you have enough money to pay your debt and your bills, and so on? If it’s at 36, if your debt to income goes from 36 to 49,
the there’s opportunity to improve their put it nicely here the opportunity to improve your managing your debt adequately. But you may want to consider lowering your dti, this could put you in a better position to handle unforeseen expenses. If you’re looking to borrow keep in mind that lenders may ask for additional eligibility criteria. So if you’re doing this just for your own purposes, you might say Hmm, and measure see if that’s true, if you come up to 36 to 49, are you having problems paying your bills and you know, the expenses that are coming up?
If so, obviously, then the debt would be something you’d probably want to see if you can lower the ratio down to 35%. Somehow, if possible, and if you were to go to look for a loan, and needed financing, at some time, this could be an obstacle to get it. So it’s also adding a level of risk involved here because you don’t have as much access to, you know, cash flow in the event that you needed it because of this, this obstacle here to it in the event that you need it so 50% or more take action, they say you may have limited funds to save or spend. So if it’s over 50% they’re saying that’s a red area for them. You know, in this in this scenario, and you would think that would generally be the case, right?
Because you’re paying over 50% of your income, gross before even taxes to to debt and so with more than half of your income going towards debt payments, you may not have much more Left to save, spend or handle unforeseen expenses with this debt TTI dti ratio lenders may limit your borrowing options. So if obviously, if it’s over 50, you’re probably you could quite well and measure it yourself, are you having problems, you know, paying the debt and your other expenses.
This could differ from, you know, person to person and your financial circumstances that will differ clearly. So there could be, you know, funny situations, of course, where people could be outliers to the norm. So you want to take this in as to one of those statistics for your financial health, and see if this does match where you’re at. And obviously, if you’re over that 50%, you might want to be looking to see if you can lower it in some way.