When you apply for a new line of credit, loan or mortgage, a creditor will run a credit check to verify your financial standing. This helps them determine if you can afford the repayments, and whether you will pay the account in full and on time.
There are many reasons your credit application could be denied. If this happens, the creditor must provide an “adverse action notice” to help consumers understand why their application was rejected. One of the reasons provided could be “excessive obligations in relation to income”.
What Does Excessive Obligations In Relation To Income Mean?
It means that your current debts are already too high to be affordable based on your gross monthly income. This is known as the debt to income ratio (DTI).
Each financial institution determines their own acceptable debt to income ratio, to weigh the potential risk factors before lending to borrowers.
Your DTI is an important part of your overall financial health as it assists you in determining whether you can afford to take on another payment.
How To Calculate Your Debt To Income Ratio?
To calculate your debt-to-income ratio, calculate your monthly expenses (excluding groceries, utilities, gas and taxes) like:
- Credit cards
Next, you divide your total expenses by your gross monthly income, then multiply your answer by 100 to obtain the percentage. You have now calculated your DTI.
What Is A Good Debt To Income Ratio?
A low DTI indicates you are less risky to lenders and that your application is more likely to be approved.
A good DTI is less than or equal to 36%, whereas any ratio above 43% is considered too high. Even a ratio between 37% to 42% can occasionally get special consideration from a lender.
“Excessive obligations in relation to income” means you cannot afford a new line of credit based on your current debt. Your DTI likely exceeds 36%.
If your application is based on this, creditors must communicate an “adverse action notice” which allows you to:
- follow up
- adjust your budget, or
- dispute a debt that might be incorrectly recorded.