How is Debt Score calculated?
How is Debt Score Calculated - Methodology
After years of working with borrowers, we got tired of the fact that there simply wasn’t a good tool to measure how healthy someone’s debt situation was and we decided to create a tool.
We wanted to leverage the best of what is already used in the finance world and chose debt-to-income (DTI) as the starting point to calculate a raw Debt Score. We liked this concept, because we believe that everyone should speak a common language when it comes to debt so we’ve largely kept the “front end” (housing debts including mortgage, insurance, property tax, HOA, or rent) and “back end” (credit card, student loans, auto loans, leases, child support / alimony, and any legal judgments). However, since traditional DTI metrics don’t tell you anything how healthy your debt ratios are for your personal situation, we decided to create a customized grading scale to evaluate your situation considering age, desired retirement age, college degree, and income growth.
Baseline evaluation criteria:
To establish the baseline for healthy ratios, we looked at the various ratios that mortgage lenders use, including FHA, VA, and other standards. Although there exists a range of “acceptable” front end / back end limits, we decided to go with the traditional 28/36 front-end and back-end ratios as the baseline for acceptable debt levels. In general, this means that a young person can afford to spend 28% of income on housing and 36% on all debts and legal obligations.
To allow for greater granularity, we remove housing costs (the “front-end”) from the total “back-end” DTI into a separate category which we call Lifestyle debt. This is set at 8%, the difference between 36% and 28%.
To this starting point, we apply modifiers to say what your debt should be given your personal situation.
We believe that we should pay off our debts and move to building assets as we move toward retirement. To map out how this should change over time, we incorporated a variety of sources: actual payoff behavior in the 2007 Survey of Consumer Finance1, the Theory of Declining Responsibility2, and other academic studies3 to develop curves that show how debt should be reduced over time. As a baseline, we use 65 as the traditional retirement age.
Desired Retirement Age
Although we start with 65 years as the target retirement age, we realize that not everyone has the same expectations. As a result, we allow users to input their retirement age. This effectively stretches (if later than 65) or shrinks (if < 65) the payoff curves accordingly.
One of the key factors to consider in assessing debt health relative to income is how quickly that income is growing. Someone with a high rate of income growth (e.g., >3.5%) will find that they are able to “grow into” a particular debt level, while those with a lower rate of income growth (e.g., < 2.5%) may find that their income simple doesn’t grow quickly enough to help them pay off debts.
To model this effect, we looked at government statistics by occupation and income growth.
Although it’s possible to do this by occupation, we simplified by considering the linear relationship between income growth and base income level. In short, those with higher incomes experienced a higher rate of growth than those with lower incomes. This is reflected in the grading scale, giving someone with a higher level of income a relatively healthier evaluation than someone else with similar debt-to-income levels, but lower base income and growth.
Because this earnings growth impact is uncertain over time, its effect is modulated by giving in proportionally less weight in the out years by using an exponential function.
College is one of the most significant investments that you can make and most of us take out student loans to finance it. Since completing a degree generally improves earnings and future earnings growth, we make an additional allowance for student debt. In general, there are no specific guidelines for college debt affordability. Most experts provide a guideline from 8% to 16%5. However, these would still be part of your total “back-end” debt-to-income. We follow similar treatment: student debt is included in your total Lifestyle debt allowance. However, if you complete a college degree, we add an additional 4% to your lifestyle debt. However, we assume that student loans are paid off within 10 years from graduation.
The borrower’s Debt Scores are “graded” by comparing the borrower’s calculated Debt Score to a determined grading scale. Again, to keep scoring consistent with the industry standard DTI approach, we keep Debt Score to a simple mathematical ratio of debt payments to income and instead modify the target ratio (e.g., the healthy benchmark, given a borrower’s factors) by the factors mentioned above as follows:
Baseline target (28%) * Age / retirement age adjustment factor * income growth factor * education debt factor
The grading scale is defined by creating graded bands of 2% for each letter grade, starting with the baseline target amount. The table below represents how a borrower’s Debt Score would be graded using traditional “rule of thumb” DTI levels as the starting point. Customized grading bands are created for each borrower’s Debt Score depending on their unique factors.