Your Credit Rating - Do Not Buy a Car

When Income Grows and You Want to Buy "Stuff"

When an individual’s income starts growing and they manage to set aside some savings, they commonly experience what may be considered an innate instinct of modern civilized mankind.  The desire to spend money.  Since North Americans have a special love affair with the automobile, this becomes a high priority item on the shopping list. Later, other things will be added and one of those will probably be a house.


Debt-to-Income Ratios and Car Payments

When determining your ability to qualify for a mortgage, a lender looks at what is called your "debt-to-income" ratio. A debt-to-income ratio is the percentage of your gross monthly income (before taxes) that you spend on debt. This will include your monthly housing costs, including principal, interest, taxes, insurance, and homeowner’s association fees, if any. It will also include your monthly consumer debt, including credit cards, student loans, installment debt and car payments.


However, by the time home ownership has become more than a distant and hopeful dream, you may have already bought the car. It happens all the time, sometimes just before you contact a lender to get pre-qualified for a mortgage.  As part of the interview, you may tell the loan officer your price target. He will ask about your income, your savings and your debts, then give you his opinion. "If only you didn’t have this car payment," he might begin, "you would certainly qualify for a home loan to buy that house."  


How a New Car Payment Reduces Your Purchase Price  

Suppose you earn $5000 a month and you have a car payment of $400. At current interest rates (approximately 8% on a thirty-year fixed rate loan), you would qualify for approximately $55,000 less than if you did not have the car payment.  Even if you feel you can afford the car payment, mortgage companies approve your mortgage based on their guidelines, not yours. Do not get discouraged, however. You should still take the time to get pre-qualified by a lender.  However, if you have not already bought a car, remember one thing. Whenever the thought of buying a car enters your mind, think ahead. Think about buying a home first. Buying a home is a much more important purchase when considering your future financial well being.


Credit Score Improvement - The first step is to get a copy of your credit report and make sure there are no errors. People with very common names may end up with someone else´s bad debt on their credit report. Identity theft is another problem. Be prepared to be patient as it is far easier to get something on your credit report than it is to get it removed. FICO® Scores are calculated from a lot of different credit data in your credit report. This data can be grouped into five categories and have different percentages of importance: 


1) Payment History - 35%, 

2) Amounts Owed - 30%,

3) Length of Credit History - 15%, 

4) New Credit - 10% and 

5) Types of Credit Used - 10%.   


These percentages are based on the importance of the five categories for the general population. For particular groups - for example, people who have not been using credit long - the importance of these categories may be somewhat different. If you have a lot of credit cards pay off the balances (but do not cancel the credit cards) to reduce the total amount owed. Do not spread the debt over more loans as the mortgage company will look at total debt. Manage your credit cards responsibly. Limit the number of inquiries on your credit. If you apply for several credit cards within a short period of time, multiple requests for your credit report information (called "inquiries") will appear on your report. Looking for new credit can equate with higher risk, but most credit scores are not affected by multiple inquiries from auto or mortgage lenders within a short period of time like 30 days. Typically, these are treated as a single inquiry and will have little impact on the credit score. Pay your bills on time, get current and stay current. Delinquent payments and collections can have a major negative impact on your FICO® score. The longer you pay your bills on time, the better your credit score. Sometimes there are not enough "lines" of credit which means not enough companies have reported information about your payment history to the three credit bureaus. This can be solved by taking out small loans and paying them off over a few months or signing up for an additional credit cards and using them so the activity gets reported. Note: Do not sign up for too many new accounts or it will have a negative effect on your FICO® score.  In some cases it will require time to improve the score. A bankruptcy, foreclosure or other bad debt may stay on your credit report for years. There are some very good credit counseling companies who can develop a plan to improve your credit. Consult your mortgage professional for referrals to a reputable credit counselor. 


Debt to Income Ratios - Prospective homebuyers must answer many questions, but the first is always "How much home can I afford?" Calculating a debt-to-income ratio will give you a good idea of how much of your income will be available for monthly mortgage payments, including principal, interest, taxes, and insurance, collectively referred to as "PITI." Most mortgage professionals agree the total amount you pay toward your mortgage (PITI), should not exceed 28 percent of your gross income. The total amount you pay in debt-related expenses, including your mortgage, car loan payments, credit card bills, student loan payments, and any other debts, should not exceed 36 percent of your income. So how much can you afford to pay each month? The first step is to determine your total income. This includes not only your regular salary but also the following: 


• Bonuses 

• Regular income from dividends and interest 

• Assistance or support payments, such as alimony or child support 

• Payment from tips or commissions  


The total of all these figures will give you your gross annual income. Dividing by 12 will yield your monthly gross income. Multiplying your monthly income by .28 will give you an idea of how much you can afford in monthly mortgage payments. For example:  Your total household income is $80,000, your monthly income is $6,667.  At 28 percent, you can afford to spend $1,867 on your mortgage per month. At 36 percent you would have a total limit of $2,400 in debt-related expenses per month. 


If you have debt other than the mortgage, you may have to adjust the mortgage amount down to stay within this 36 percent limit. Once you know your total debt limit you are ready to consider your loan options and use a calculator to see how much you can buy. If you find a mortgage loan with a monthly payment of $1,500, you would be well under your $1,867 limit. Next, factor in your average monthly credit card expenses, car payments, and any other rotating charges. If that total comes to $800, your total debt burden would be roughly $2,300, $100 less than your $2,400 limit. Ultimately it is up to you to apply these formulas and ratios to your own financial situation. Remember, while the numbers may help you get approved for a loan, they won´t provide you with the whole story. Some people can afford a little more, while others should pay less, depending on lifestyles and other factors.