Borrowing Money Is Like Jumping Hurdles

 

 

Imagine yourself seated across the desk from a loans officer, waiting anxiously to hear the verdict.  Will your request for a loan be approved?  Initially, you felt confident and now you have doubts.  What exactly is the loan officer analyzing?

The credit process can be likened to jumping over hurdles.  As you jump through the following points, you get a sense of the criteria the loans officer puts under the microscope to analyze whether you qualify.  

Hurdle #1: Your Credit Report.  Your credit report will be your first means of defense.  If you have always consciously made your payments in a timely manner, meeting all your loan obligations, then you should have no concerns.  Quite often, people don’t realize what’s involved in maintaining a healthy credit report.  To ensure you understand your credit report and credit score, click here for additional information from Financial Consumer Agency of Canada.  If your credit score is low, you can improve this by implementing some sound strategies as shared in the previous blog, Protect your Score.

Hurdle #2.  Capacity to Make Payments. You can be assured your income plays a significant factor in determining whether or not your loan is approved. Capacity is measured by using ratios: Gross Debt Servicing (GDS) and Total Debt Servicing (TDS).  These are math calculations to ensure your debt payments don’t interfere with your ability to manage day-to-day living expenses.   

GDS focuses on your ability to meet shelter costs, rent or mortgage payments.  That’s all it does.  Generally, when applying for a mortgage, this ratio is used to measure your ability to manage payments.  The amounts factored into the calculation are: mortgage payment (including principal and interest), property taxes, and heating costs.  If the mortgage is for the purchase of a condo, then 50% of the condominium fees are also included.  Once these amounts are tallied, the total is divided by your gross income and then multiplied by 100 to determine your ratio.  Keep your fingers crossed! The guidelines are 25% to 30% of gross income. (Sometimes 32% is acceptable.) The lower the ratio the better since this indicator measures the percentage of your gross income required to cover shelter payment.  For example, if your ratio is 15%, then only 15% of your total gross income is funding your mortgage/rent payments. 

The formula for calculating GDS is as follows (calculate either monthly or annually):

 

Payment of principal and interest on mortgage                                              + property taxes                                              + heating costs                                              + 50% of condominium fees (if applicable) GDSR =                    -----------------------------------------------------------------------------                                              Gross Income

 

TDS calculates your ability to manage all debt obligations including child and spousal support payments.  For many, the big surprise is the payment amount for credit cards is calculated on the available credit limit, not the outstanding balance.  You may have an outstanding balance of $5,000 but your MasterCard credit limit is $15,000.  Your payment used in the calculations will be $450 (3% of $15,000) since you have access to this credit at any given time.   Because you haven’t used the entire balance today, doesn’t mean you won’t tomorrow.  So lenders realize that if you do, then monthly minimal payments will increase.  Although having access to a high credit limit may be beneficial, the full payment affects your TDS ratio as well as the credit limit is the amount shown as a liability on your Net Worth Statement.  

Since you are aware of the amounts involved in the TDS calculation, tally the total, divide by your gross income, and multiply by 100 to determine the ratio.  Ideally your TDS should be 35% or less.  Some institutions allow a ratio of 40%.  Although your loan may be approved despite your high ratio, you have to consider the financial situation in which you may place yourself.

Here’s a glance at the formula for calculating TDS (calculate either monthly or annually):

 

Payment of principal and interest on mortgage                                              + property taxes                                              + heating costs                                              + 50% of condominium fees (if applicable)                                              + payments on other personal loans TDSR =                   -----------------------------------------------------------------------------                                              Gross Income

 

Hurdle #3: Your Net Worth (Capital).  Another measurement of creditworthiness is your present net worth. When assigning a value to assets such as motor vehicles, snow machines and the like, use realistic values. Do not overvalue them. Vehicles are a perfect example since they quickly depreciate. In reality, question whether someone would be willing to pay this amount for a particular asset. 

To help create your Net Worth Statement, click here to use this on-line calculator. Once your statement is created, liabilities are subtracted from assets. If your liabilities are greater, then your negative net worth is alerting your loans officer to a potential problem.  Generally, the one exception for showing a negative net worth is if a student acquires debt in pursuit of an education. Technically, as a student, you are an asset with the ability to generate an income to pay off your student loans. 

 

Assets Everything You Own	Liabilities Everything You Owe
Net Worth (Assets – Liabilities)

 

 

Hurdle #4: You (and Your Character).  It’s about you.  Attitude is everything.  Attitude shows up in your credit report, your ability to be employed, and in your conversation with your loans officer.   The important question to answer is: Will you uphold your promise to repay the loan? As time goes on, you accumulate a history which will follow you.  Establishing a strong relationship with your loans officer will be important.  Over time, you, no doubt, may require more than just one loan. 

 

Hurdle #5:  Collateral.   The reasoning behind using collateral to secure a loan is assurance that some or all of the money can be retrieved if you happen to default on your loan.  So many unforeseen events might occur to cause you to miss payments and neglect your financial obligations. Eventually, the only recourse remaining for the lender is to sell your asset to repay the loan.  Whether you assign your car, investments, or house, as collateral, you pledge a promise to pay back the debt. In the event you don’t, then the asset will no longer be yours.  When examining all the criteria to approve your loan, collateral generally would be the last consideration.

 

How does everything look as you jumped over the hurdles?  This information cracked open the door to the credit assessment process. Everyone’s borrowing needs are different; special consideration is given to special circumstances.  Guidelines are in place as tools to help with the process.  Not only are the financial reports and ratios analyzed but your loans officer also implements good judgment on your behalf.  When you continue to meet your loan obligations consistently over time, you will build both a trusting relationship with your lender and a strong credit history.  This best outcome when borrowing money becomes necessary to fulfill your dreams.   

 

 

Protect Your Score

Have you watched your favorite football team take a commanding lead in a game, ensured a win because their score was twice that of their opponent? Then the drama begins. Suddenly this fabulous score doesn’t look as great because they are being outplayed.  They may have slacked-off; took a few penalties or dropped the ball because they misunderstood the play. In the end they didn’t play defensively.

What about you? We take part in a game where we must protect our score.  Every time we borrow money or require a service {cell phone, rent an apartment), someone checks your credit score to ensure you are creditworthy.  Quite often people do not understand they are graded on their performance. Credit reporting agencies, like Equifax or TransUnion, are keeping tabs on “your stats” to determine how well you manage credit.  The better manager you are of your debt the higher your “Credit Score”; the poorer you are at managing your debt, the lower your score.  The good news is you can defensively put into action strategies to either protect or improve your score.  

Five Ways to Create the Winning Play with Your Credit

1.  Make your monthly payments on time. Knowing the due dates of your debt obligations in advance ensures you have set money aside for monthly payments.  Being consistently late with your payments will appear on your credit and lower your score.

2.  Pay the minimum payment even if you are unable to pay the entire balance on your credit card.  Even if the minimum payment appears insignificant (i.e. $10), ensure you pay at the very least this minimum amount.  If you don't, you are sending a message to the world you can't make a larger payment either ($310, $510). Many people opt to miss the small payment and vow to pay double the amount the following month.  This strategy ends up hurting their score. 
 

3.  Limit the number of credit inquiries others conduct on your credit report.  (i.e. credit cards company, car dealerships, financial institutions).  Most people do not understand that an excessive number of credit inquiries “take hits” against their “Credit Score.”

4.  Stay within your credit limit. Credit card companies are notorious for allowing you to exceed your credit limit especially when you diligently make regular payments.  You may trigger a penalty which results in a transaction fee; but what’s worst--your credit score also drops.

5.  Resolve unsettled disputes. By taking a stand and refusing to pay for an unsatisfactory service or product, you may find this unpaid bill appear on your credit report.  The best you can do is to reach a compromise to ensure the unpaid bill doesn’t jeopardize your credit report.

Now that you are informed about ways to protect your score, Financial Consumer Agency of Canada has a short five-question quiz to test your knowledge. If you are interested in taking the quiz, click here. 

THE CHALLENGE:

•  if you don’t know your score, apply for your credit report. 
• if you don’t like what you see, put into effect winning plays to improve your score.
• if you like what you see, continue to protect the score.