Financial Know-How

Since capacity (your ability to make the monthly payments) is usually the biggest determinant in most credit applications, I will focus on this factor in today's post. Specifically, I'm going to show you how you can take the two debt ratios that banks use to gauge capacity, TDS and GDS, and figure out what's the most you will likely qualify for based on your current income and expenses.

As a quick reminder from my previous post "The 5 Cs of Credit" that TDS looks at your overall monthly obligations and GDS looks only at your housing obligations as a percentage of your total gross income (before taxes). Banks want to see these ratios under 40% and 32% respectively. Since you know these two maximum percentages, you can calculate roughly how much you can qualify for.

The easiest way to explain this is to use a simple example. Say you want to buy a car. You have an income of $40000, pay $800 rent, and have a $3000 balance on your credit card (therefore minimum payment is 3% or $90 on credit card). But before going out to look for a car (or a house for that matter), you want to know approximately how much you can qualify for. Here is an easy and effective way to determine that yourself.

From the example, if maximum allowed TDS is 40% of income, then 40% of $40k is $16k or $1333 per month. That means the banks want to see your total overall monthly obligations to be no more than $1333. Since $800 plus $90 is being used to pay for rent and credit card, then the bank will let you borrow up to an amount where the monthly payments is (1333-890=) $443/month. To find out how big that loan is, use a loan calculator that allows you to invert the calculation. BMO has a good one.

So if the bank is currently offering a 4 year loan at 10% interest, then given a payment of $443, you will qualify for a $17,466.67 loan maximum. A 5 year loan with the same rate qualifies you for up to $20,849.96.

A quick check of the GDS shows that 800 / (40000/12months) = 24% so you're below the 32% guideline.


For a mortgage application the calculation for housing costs gets a little more complicated because you have to add in other costs of maintaining the home in addition to the monthly mortgage payment. In a mortgage application, total monthly housing costs  = monthly [mtg pymt + property tax + heating + fire insurance] + 6 months condo fees if applicable. If you don't know these other figures then ask around to estimate it. If you found a home already then the MLS listing and realtor can give you those figures for that particular home. Just minus those totals from the 40% of your income to get the mortgage payment amount and use an invertable mortgage calculator (I'm in the process of finding one for you) to figure out the mortgageable amount or use a normal mortgage calculator and do trial and error to find the mortgageable amount.
 
The calculation above is generally used by all adjudicators in every type of credit application. From credit cards and overdraft protection to loans and lines of credit. Each bank may have different lending policies but they all follow the same 32/40 lending guideline.

One thing I want to remind you of is that capacity is only one of the 5 Cs of Credit that determines how much and whether your credit application gets approved. But it is generally the most important factor in most applications, especially for larger amounts like a mortgage or car loan. Also, some financial institutions may calculate your TDS based on your credit limits and not your minimum monthly payments.

Most people believe that if you always make your payments on time then you will have good credit. This is not true. The only thing that making your monthly payments on time does is ensure that your credit rating does not drop. Your credit is actually determined by more important factors. These factors are what I call long-run factors.


Think of it like this. All things being the same, if you never ever miss a monthly payment, your credit score will reach to a certain level and stay there. That level is called the long-run level or potential level. (I use the term level, rating, and score interchangeably here.) The biggest determining factors of your long-run level is the amount of open debt you have and the length of time you've had them.


Otherwise known as revolving debt, open debt are things like credit cards, lines of credits, and department store cards. They allow you a lot more flexibility than closed debt, such as loans and mortgages. How much you owe on these debts will be the biggest factor in setting your long-run or potential credit score.


What credit agencies look at is how much you owe as a percentage of the total open credit limit. Say you have two credit cards, one has a $2000 limit and another has an $8000 limit. You have a total open limit of $10000. If you own $1000 on each, you owe 20% of your total limit.


To understand and manage your long-run or potential level, think of the 30-80 rule of open credit. If you owe anywhere between 1 and 30%, your potential level will increase to its highest level dependent on how long you have had these two credit cards. The longer the period the higher your long-term level should be.


Now if you owe anywhere between 30-80% and you always make your payments on time, you should not see a change in your potential or long-run level. If you increase the amount you owe to anywhere between 80 and 100% of your total limit, your credit score will go down to a lower potential level even if you always make your payments on time.


That being said, you should also try to make your monthly payments so as to not hurt your credit in the short-run. Being late on any payment for more than 1 month will decrease your score in the short-term. Only by not being late again for a long enough period of time will your credit score eventually start going back up to the potential level (which I have explained is determined largely by the percentage you owe on your total credit limit and the length of time you've had these credits).


It's important to note that financial institutions will only report late payments to the credit agencies if you're over 30 days late. That means it's okay to be late on your loan or mortgage payments as long as it's not over 30 days late. Being over 30 days late will decrease your score even though there is no change in your potential level (given no change in the percentage bracket of open credit you owe).


So those are the two biggest things that affect your credit rating, which luckily you have control over. The lesson here is to never be over 30 days late on any payments so that it doesn't negatively affect your credit score in the short-run, owe less than 30% of your total open credit to raise it to its highest potential, and never close your oldest credit facilities. And try not to owe more than 80% if you can. That means the next time that lady at the mall offers you a credit or department store card, you'll be doing yourself a favor by getting the card even if you don't plan to use it as it will only increase your total open credit limit and lower the percentage that you owe.


Now of course there are many other factors. As I've mentioned, the longer you've had the credit card, loan, etc, the higher your potential credit score. In the short-run though, there are other factors you should keep in mind. One is that the more times someone (the bank, etc.) checks your credit history within the last 12 months, the lower your credit score. This is because it is a sign to credit agencies that there's a problem. Most people don't need multiple checks on their credit score in a short span of time unless there's a problem. Each time anyone checks your credit, your credit score decreases, at least in the short-run. So don't let anyone check your credit unless it's absolutely necessary.


Another sign of instability is the amount of times you've changed jobs or change address. The more that happens and the agencies are aware of this, the more downward pressure there is on your score. But luckily this is a short-term effect and the score can be re-raised eventually to its potential level.


Depending on how long one has had the credit accounts, if you have a spotless credit history but your open credit utilization is over 80%, you will have a potential score of about 650.


So now you know. Always paying your bills on time gives you a spotless credit history but it does not mean you have the highest credit score possible.


Well I hope you understand what I've explained. Use it to your advantage and make sure everyone around you, your family, friends, and coworkers, are fully aware of the mechanics behind what determines their credit scores. This is how it works in Canada and the US and this is likely how it works in every other country.

Unless you have all the money in the world, eventually everyone at some point will need to borrow money from the bank. Whether you want to purchase a car, establish a credit history, consolidate debts, or buy a home, there will come a time when you will need to apply for credit.

Today I'm going to explain what all lenders look at when evaluating any credit application. These factors will determine whether you will be approved for any credit be it a $500 credit card or a $500,000 mortgage. Being aware of the factors that affects your application will help put you in a better position the next time you apply for any credit. Theses factors are called the 5 C's of credit.


1. Credit Rating

This factor is based on your credit score, the higher your score the more likely you will be approved. Banks want to know that they'll be getting their money back, and preferably on time as promised. Your past credit history will be a good indication of that. The lower your rating, the higher the risk the bank must take on as a lender to you. This is why it is important to make sure you have good credit in case you ever need to borrow money.

(Read more: Good Credit: How It Works & What They Never Tell You)


2. Capacity

This measures your ability to pay and is based on your cash flow (income vs expenses). Banks want to make sure you have enough income to meet your existing monthly obligations plus the new loan payments. It is an industry standard to gauge your ability to service your debts by two debt ratios:

    * The GDS (gross debt service) ratio measures your housing costs as a fraction of your gross income. If your rent is $1000/month and you make $4000/month, then your GDS is 25%. If you own a home or are applying for a mortgage, then your housing costs would include your monthly [mortgage payment + heating + property taxes + condo fees + fire insurance]. Banks want to see the GDS under 32%

    * The TDS (total debt service) ratio is a wider measure of your ability to pay as it also includes all your other monthly obligations in addition to your housing costs. So if you also have credit card monthly payments of $200 and a loan payment of $200 then your total debt ratio will be 1400/4000 or 35%. Banks want to see your TDS under 40%.

Meeting these two ratios will show that you are fully capable of servicing the added debt you are applying for.

(Read more: Determining How Much the Banks Will Let You Borrow)


3. Capital

This factor measures your assets and is a component of your net worth. The more assets you have (car, bank accounts, investment accounts, house) the more likely you will be approved. Having assets can only help your application so it serves your best interest to disclose as much as possible them. Even if your debt ratios are above the guidelines set or your credit is not that great, having sufficient assets might be the deciding factor for them to approve the loan.


4. Collateral

This factor serves as insurance for the bank. The more assets you are willing to put up to insure the bank in case of a default, the more likely you will be approved for a loan. A fully insured debt is called a secured debt and because they completely eliminate the risk of the bank they typically offer the best interest rates and easiest approval. Such credits include secured loans, lines of credits, and credit cards. In the case of a mortgage, the house will be used as collateral in the event of a default. The more the down payment or equity you have in the home, the less risky you are as a borrower.


5. Character

This last factor is the least important (but I have successfully used this many times to convince the banks to approve credit for my clients). It looks at how you are as a person. It looks at your job stability, your education, your profession, your relationship with the bank, and these sorts of things to try to gauge what type of person you are and whether a person of your character is likely to default on a loan.


These 5 Cs of credit are what all adjudicators look at when evaluating every credit application for any lender. Remember they are just lending guidelines and are not written in stone. Having a bad credit rating can still get you approved for a loan if there is collateral or if you have a lot of assets. You can still be approved for a loan if your debt ratios are higher than 32% and 40% if you have excellent credit. You can be approved for a mortgage with no down payment (no collateral) if you have a very high income (capacity). Which factor will be the most important in your credit application will depend on the type of credit you are applying for.

In a future post on credit I will go into more detail on the factor that is generally the most important in any credit application (especially a mortgage) and that is capacity - your ability to service the debt. By looking at your expenses and income, I will show you how to use your TDS and GDS to determine the maximum amount of money the bank will let you borrow when you are looking to purchase a property (or any type of credit for that matter).

Figuring out this amount on your own before speaking to the bank or realtor is the very first thing you should do when planning to buy a home (or even applying for a small loan).