Second to a credit rating, the Total Debt Service Ratio (TDSR) is an important metric that lenders use to evaluate a borrower’s ability to take on additional debt. While a credit score itself will provide a picture of a borrower’s tendency to pay off loans based on past history, the TDSR shows the lender a picture of the borrower’s current capacity to pay off new debt. By understanding how the TDSR is taken into consideration by lenders, a borrower is better able to plan their finances to meet their borrowing and saving needs.
The first aspect of the TDSR calculation involves tallying up all of the living obligations that the borrower is already making. This amount would include the minimum payments required on any outstanding line of credit balances (ie. 3% of a credit card payment), the installment payments being made towards a time planned personal loan, and any other legal obligations that the borrower may have.
Additional obligations will generally include such costs as alimony payments, taxes, and rent. However, it is interesting to note that utilities bill payments, groceries, and gas expenses are not taken into account in this equation. Those latter expenses are ignored because they are assumed to be included in the funds that are beyond the TDSR calculation itself.
The second part of the TDSR calculation requires that we find a total of the borrower’s after-tax incomes. This amount will include all incomes that are reported as legitimate and stable for approximately 2 years. Incomes from employment, investment, child support, pension, and asset returns are all relevant, and all contribute to improving the TDSR of the borrower.
Upon having calculated these two amounts, we can insert them into the TDSR ratio and evaluate borrowing capacity. TDSR is calculated by dividing Living Obligations by After-Tax Incomes, and then multiplying the resulting number by 100 to return a percentage. This percentage represents the amount of our current income that is being applied towards debt. A lower percentage represents a borrower with a greater capacity to take on additional debts, while a higher percentage represents a borrower that is already servicing a great deal of obligation.
Think of it this way: A borrower with a TDSR of 25% will pay out $0.25 of every after-tax dollar they earn towards a living or debt obligation. Because of the implications of such a percentage, lenders will generally prefer that borrowers maintain a TDSR of no more than 40-50%. That being said, there are a number of ways to adjust, circumvent, or manage TDSR to make sure that it is not explicitly binding as a loan constraint. A number of these strategies will be discussed in the coming week.