Debt is a common problem, especially in today's world where it seems everyone uses credit to pay for things. But debt doesn't have to be excessive. You can use credit responsibly by thinking about your spending habits and making sure you understand what an acceptable level of debt is.
Personal Tolerance for Debt
If your debt is causing you stress, that's the first sign that you have exceeded your acceptable level of debt. Develop a plan to pay off the debt. Make a realistic budget and figure out a time frame for paying everything off and post the plan in a visible spot to remind yourself that you're working on it.
Calculate your debt-to-income (DTI) ratio by dividing the total amount of your debt by your annual income before taxes. Banks and credit lenders usually consider a DTI of less than 30 percent as acceptable; anything higher is considered "over-extended."
Mortgage and Loan Approval
Banks and other financial institutions set specific limits on debt-to-income ratios when you apply for a loan or a mortgage. When you apply, provide proof of income, such as pay stubs, and you'll have at least one interview either face-to-face or over the phone with a representative. The key to being approved for a loan or mortgage is to be prepared to answer any questions about your income and assets and to have an acceptable debt-to-income ratio. For mortgage loans, the lender calculates two kinds of DTI: front-end and back-end. Front-end DTI is your mortgage payment versus your monthly income, and back-end DTI is the amount of your total liabilities versus your monthly income. Banks often will not approve mortgages where your front-end DTI is over 28 percent and they won't approve mortgages or personal loans if your back-end DTI is over 36 percent.
It's important to note that when you apply for financing through third parties, such as when you buy a car from a dealer, you may be pre-approved by the company selling you its product. But when you go to get the financing, the dealer or company still goes through a bank that will be assessing your debt-to-income ratio, your credit score and your credit history. So be aware that when a third-party says you're approved for financing, they probably just looked at your credit score and not your debt. When the bank goes to finalize the loan, the standard of 36 percent DTI will still come into play.