When it comes to applying for a big loan or mortgage for a new home, the holy grail is almost always about having that perfect credit score. For most people, the significance of an excellent credit rating has been hammered into their minds by the time they have made their first dollar. So why is it, then, that your household income is not used to calculate your overall credit score when it still partially dictates the amount of credit you’re granted?
Having a high credit rating signifies that you are a reliable borrower who will pay back your loan in full and on time. So in order to make those payments, wouldn’t common sense suggest you would have to make enough money to cover what you owe? Wouldn’t someone making $100,000 a year asking for a $10,000 loan be more apt to repay it than someone who makes $30,000?
How Your Credit Score Is Calculated
There are multiple categories that are used to determine your credit worthiness. For your FICO Score, they are grouped as follows:
- Payment history: This category makes up about 35 percent of your credit score. Using all your applicable accounts such as credit cards, retail accounts, installment loans, mortgage, etc. and factoring in whether or not you paid each on time. Any blemishes here would hurt your score significantly.
- Amount owed: About 30 percent of your score depends on how much debt you already owe. The less debt you owe, the better position you’re in to repaying any new loans.
- Credit history: Think of this as your track record. About 15 percent of your rating is based on how long you’ve been proving your credit worthiness.
- New credit: This makes up 10 percent of your score. Any recent inquiries or opened accounts are factored in, as well as re-establishment of good credit history.
- Types of credit used: The last 10 percent is made up of the types of accounts you have open. For example, having a mortgage out would be different if you had credit or retail cards open.
These five categories make up the calculation of your magic credit number that lenders use you evaluate your reliability to repay a loan. So as you can see, your income doesn’t directly fall into any one of those categories. That doesn’t mean, however, that how much you earn annually isn’t important.
Your Income Matters To Lenders
The reason why your credit score doesn’t factor in your income is because it is just one of the elements that lenders use to evaluate your loan or credit application. The purpose of the credit score is to indicate to a lender whether or not you are a reliable borrower.
If your credit history indicates that you consistently make your payments on time in the past, lenders will understand that you are responsible and trustworthy. If you’ve been inconsistent and neglectful, it doesn’t matter how much you make; you become a potential liability.
A borrower’s income level doesn’t determine how reliable they are and the purpose of a credit score is to do exactly that. Income suggests that a borrower may have the ability to repay a loan, but just because they can doesn’t necessarily mean they will. So the good news is if you lose your job or take a pay cut, your credit score isn’t affected unless you miss a payment.
However, that isn’t to say that income doesn’t matter. Credit scores are just one category that lenders use in their own calculations. Other criteria include the debt-to-income ratio, where income becomes a factor.
Managing Your Debt-To-Income Ratio
As a general rule of thumb, a borrower shouldn’t exceed a debt-to-income ratio of 36 percent. To calculate, take your monthly debt payments and divide it by your monthly gross income. If that number exceeds .36, you’re pushing your limit.
If you’re thinking about applying for a loan, you should understand that having a high credit score alone won’t get it done. It’s about having the right combination of creditworthiness and ability to repay the loan (debt-to-income) to lenders.
