Consumer Credit and Total Debt Service Ratio Essay

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Introduction

Credit is the confidence allowing one party to provide resources to the other without immediate payment. These resources might include finance (loan); goods and services (consumer credit). Credit can best be classified into consumer credit, international credit, real estate credit, government credit, investment credit, and commercial credit. Specifically, consumer credit is the amount of credit acquired in purchasing a product, consumable non-investment goods/ services with immediate value depreciation. These include automobiles, trailer loans, recreational vehicles, and education services. However, credit is usually pegged on the creditworthiness and reputation of clients. The cost of credit can be mandatory which includes interests, application fees, and other charges or optional costs like credit insurance.

Consumer credit risk occurs as a result of non-repayment of availed credit products like mortgages, credit cards, unsecured personal loans, and overdrafts by a consumer. Lenders usually use credit scorecards to predict consumers’ credit risk behavior. Scorecards may be an application, collection, or behavioral. This method attributes a score to a given customer or his account thus indicating the predicted consumer behavior under different environments. Data of importance may be obtained from application forms, credit reference bureaus, or existing customer products with the same lender.

Total Debt Service Ratio (TDS)

The total debt service ratio is a measure used by financial lenders to estimate the possibility of awarding a loan facility. It, therefore, provides a groundwork assessment of whether a potential borrower is over-indebted or not. It shows therefore the proportion of gross income already spent on expenses related to housing and similar other payments.

Formula

This ratio is sometimes misleading due to its inclusion of revenue before taxes instead of after taxes.

Decision rule

Annual income is $65,000.00, annual heating costs are $4,800.00, monthly property taxes are $275.00, monthly credit card payments are $375.00, and their monthly mortgage payment is $1,200.00.

A ratio of 40 percent TDS after-tax shows that 60 percent of your cash income goes to debt and housing costs. Receiving a ratio of less than 40 percent means that the potential borrower has acceptable or favorable debt levels.

TDS = 4800+ (275*12) + (375*12) + (1200*12)/ 65000

= 27000/65000

= 0.4154*100

= 41.54%

Decision rule: any ratio of less than 40 percent portrays the potential acceptable debt level of the borrower. In our example above, the customer has a value greater than 40 percent. It is 41.54 percent which shows that the person has exceeded the acceptable levels of debt thus has an unfavorable ratio. This means that the person is so much indebted and might most likely default on any facility advanced to him.

The high TDS values may be reduced through first, increasing the earning levels and revenue sources. This will increase gross household income thereby reducing mortgages to acceptable levels. However, most of these costs are considered to vary essential in life and therefore hard to reduce. The second method is reducing the debt service obligations through exchanging high-interest debts with low-interest debts, paying off your debts, and reducing monthly car loan repayments. Finally, as a last resort, reduce your monthly mortgage repayments by taking low-interest mortgages or only buying cheaper homes, and increasing the deposit amount for your loan facility.

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IvyPanda. (2022, April 30). Consumer Credit and Total Debt Service Ratio. https://ivypanda.com/essays/consumer-credit-and-total-debt-service-ratio/

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"Consumer Credit and Total Debt Service Ratio." IvyPanda, 30 Apr. 2022, ivypanda.com/essays/consumer-credit-and-total-debt-service-ratio/.

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IvyPanda. (2022) 'Consumer Credit and Total Debt Service Ratio'. 30 April.

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IvyPanda. 2022. "Consumer Credit and Total Debt Service Ratio." April 30, 2022. https://ivypanda.com/essays/consumer-credit-and-total-debt-service-ratio/.

1. IvyPanda. "Consumer Credit and Total Debt Service Ratio." April 30, 2022. https://ivypanda.com/essays/consumer-credit-and-total-debt-service-ratio/.


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IvyPanda. "Consumer Credit and Total Debt Service Ratio." April 30, 2022. https://ivypanda.com/essays/consumer-credit-and-total-debt-service-ratio/.

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