Understanding How a Debt Score Is Calculated
Average consumers are used to dealing with credit scores and credit histories when assessing personal finances. These reports are not always helpful because they simply state how outside lenders will view a household. The debt score system was established by a private company in order to provide actionable and useful information to consumers. The score shows how well a household is managing debt in different categories when compared to commonly accepted industry standards. The metrics and calculations are closely related to debt-to-income ratio algorithms that mortgage lenders use. Several factors are assessed when determining a debt score.
The first number that is used to determine a debt score is the amount of money owned each month or year related to housing. This is traditionally known as front-end debt when calculating a debt-to-income ratio. These debts include property taxes, mortgage payments and home insurance payments. Renters include monthly rent, fees and insurance. These metrics are calculated separately because they are expenses that most people share.
Lifestyle debt means calculating all monthly expenses that are related to purchases and programs that result from specific personal choices. This includes all credit card debt, car loans and leases on properties that are not a primary residence. This type of debt also includes any payments required because of a court order such as child support or alimony. These debts are not shared by everyone. They are graded differently because lifestyle debt should occupy a lower percentage of income than other types of debt.
Some companies providing a debt score will separate educational debt from lifestyle debt since it can be handled differently. Educational debt means student loans, personal loans and other types of borrowing that is directly related to a college education. This debt is separated from lifestyle debt in some instances because it can consume a larger percentage of income in the years after college and might skew the reported score for younger people.
Scoring on many reports is present as a letter grade from A through F. Each letter represents a particular percentage range. The letter grades are associated with different percentage ranges depending on the category of debt being scored. One example is a grade of A. A grade of A for housing means that less than 28 percent of income is spent on rent or mortgages. A grade of A for lifestyle debt means that less than 8 percent of income goes to those expenses. It is possible for someone to have drastically different letter grades for each form of debt.
The purpose of a debt score is to show the financial health of an individual based on age, income and expenses. Several statistics are used to determine the most appropriate level of debt for a person or family. The average percentages go downwards with age. A debt score above the baseline means a household has taken on too much debt. Individuals with a lower score are in a better position to save for retirement. The score can be used to adjust monthly spending and savings in order to change the debt score to a more appropriate level.
This blogpost is provided on behalf of Prudent Financial Services, a provider of bad credit personal and car loans.