Welcome back to Making Cents of Finance! We’re continuing to break down the 4 C’s of Credit, where we will discuss the second item—capacity. In the last article, we talked about personal credit history and its impact on our overall creditworthiness. If you’re wondering what the 4 C’s of Credit are, you can go here to read our credit overview.
What is Capacity?
Simply put, capacity is your ability to pay back the money you borrow as indicated by your current income and standing financial obligations. Capacity is much more complex than the simplistic explanation, however. The common phrase of “debt to income ratio” is one of the factors in which credit capacity is based on. Below, we will break down the building blocks that make up the structure of capacity.
Debt to Income Ratio
Many of us have heard mention of our debt to income ratio (DTI), but what is it and how does it affect us? When applying for credit, it is assumed that each application has an average monthly income as well as any recurring monthly debt payments. To determine our DTI, we divide our monthly debts by our monthly income. The general idea regarding DTI maintains that wider the gap in your DTI, the more likely you are to get approved for larger loans.
Debt to Equity Ratio
Like your DTI, lenders will also consider your debt to equity ratio (DTE). Rather than comparing the amount of your monthly bills with the amount of inflowing cash you have, however, lenders look at your regular monthly debt to your total assets. The common train of thought is that any DTE ratio at 80 percent or higher puts us in the high-risk category to lenders, which greatly diminishes our chances at being approved for further credit accounts.
What if one or more of my ratios is less than pleasant?
I like to view credit as a living, breathing being. What I mean by this is that everyone’s personal credit and creditworthiness are constantly evolving with the ebbs and flows of life events. For example, we may graduate college with tens of thousands of dollars in student loans and a hand-me-down 1996 Chevy Beretta and making $30,000 a year. Five years later, we may have paid off the majority of our student loans, but have had to finance a new vehicle, gotten a raise or higher paying job, and are looking at buying a home or starting a family. This scenario is the fairly standard “American Dream”, but life rarely works out that way.
Imagine a recession hits and we are let go from our employment or we get a divorce. There is still debt to be paid, but now we are facing a significant cut in income, or even having no income at all for now. What do we do then? First things first, we need to make a plan. Making a plan starts out with sitting down and looking at the debts we have and the amount of money we have available. This is the time in which we are forced to make a strict budget and stick to it. Join us for our next article, where we will be discussing the third of the 4 C’s of Credit: Collateral.