10 Myths About Credit: Myth #9 (It’s All About Credit Score)

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10 Myths About Credit: Myth #9 (It’s All About Credit Score)

Myth: A good credit score is all you need to get additional credit from a lender.

Reality: Having a good credit score will get you part of the way, but it does not guarantee approval of additional credit. Other factors may include:

  1. Relationship with the lender
  2. Assets (i.e. house, land)
  3. Employment history
  4. Total Debt Service Ratio (TDSR) & other financial ratios

Even though all 4 of these points are important, I will focus on the last point, total debt service ratio for the purposes of this post.

Total debt service ratio (TDSR) looks at the percentage of gross income that goes to covering ones housing costs plus the cost of servicing their existing debts (making minimum payments on their debts)

TDSR ratio

 

Here are the parts that make up the TDSR formula in greater detail:

Numerator (top part of equation):

  • Monthly Rent payments (including heat) OR mortgage payments (including heat & property taxes)
  • 50% of monthly condominium fees (if applicable)
  • Monthly alimony payments (especially if they are court ordered)
  • Monthly Debt Payments (minimum payments):
    1. Credit cards payments
    2. Car lease payments
    3. Student loan payments
    4. Any other debt payments

Denominator (bottom part of equation):

  • Monthly family gross income

These values can easily be annual amounts like the formula above but for simplicity purposes, I used monthly because people receive monthly bank & credit statements. As long as you are comparing apples to apples, then it should come to around the same percentage amount.

As a general rule of thumb, larger and tier 1 banks (top banks) will consider extending additional credit to someone if their TDSR ratio is 40% or less. Some may go as high as 44%. The lower your Total Debt Service Ratio the better because this means that less of gross income is going towards your housing costs (mortgage & utilities) a servicing existing debt.

Private lenders may extend credit beyond a 44% TDS ratio, but usually at the expense of higher interest rates and stricter lending terms.

Here is an example:

Person A (monthly values)
Rent (heat included in rent) $1,000
Student loan payment $250
Credit card (min payments) $50
Unsecured line of credit (min payments) $50
Car payments (min payments) $250
Total TDS expenses $1,600
Gross Income $3,800
TDSR ($1,600/$3,800) 42.10%

 

Person A is right at the cusp of getting to the threshold of 44% that many 1st tier banks will not go past. This does not mean that Person A will not be able to receive additional credit, but it may require going to a private lender which will charge significantly higher interest rates and normally have stricter terms to comply with.

You don’t actually have to do this calculation by hand, here are a few great TDSR calculators that will determine your ratio for you:

CMHC TDSR calculator

TD TDSR calculator

What are the two best ways to reduce the TDS ratio?

  • Reduce expenses
    1. Pay off debts
    2. Consolidation loan. May help lower debt & reduce total monthly minimum payments
    3. Reduce housing costs (i.e. relocate to find cheaper rent or sell and buy more affordable home)
  • Increase gross income
    1. Get a second job
    2. Find a higher paying job

 Solution: Live below your means and pay off debts.

The credit score/report is a starting point, but it definitely is not the whole picture. In many cases, someone can have a pretty good credit score and be making minimum payments on their debts each month and still have a very high total debt service ratios. Financial ratios like these (and others) are very telling and help lenders make decisions about extending credit.

Categories: Credit

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5 replies

  1. Great post (as always)! Thanks so much for sharing. 🙂

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  2. Another important post that can influence the finances in many lives. Your clarity and ability to use real living scenarios will help reader’s identify with the subject. You will also help create greater savings by placing people in better situations to borrow money at lower rates. You are a true (excuse the pun) asset! 🙂

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  3. You are on the money. Credit score is just one of those things that lenders look at when deciding whether or not to extend a credit to somebody else. When I obtained a personal loan a couple of years later, the lender requested not just my credit report but also my employment history and total debt service ratio. I was lucky that my debt wasn’t a lot and only needed the personal loan to reduce my overall interest rate so I could pay all my debt faster and pay less in interest.

    And yes, you are correct the lenders can extend credit to those who are above their requirement (i.e. higher debt ratio than they required) but at the expense of higher interest rates.

    Great post, indeed.

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