Your Debt Score: What it is and Why It’s Important
Your Debt Score is one of the most important numbers you can know if you want to determine your overall debt health.
In finance, lenders use the “3 C’s of lending” that define whether or not a loan is a good one to make: Creditworthiness, Capacity, and Collateral. Creditworthiness is usually determined by your credit score, which really only measures how likely you are to continue making payments based on your past behavior. Capacity is how much you can afford to pay based on your income and is usually measured by Debt-to-Income (DTI). Collateral is whether or not the loan is backed by a physical asset (like your home or car) that can be claimed in case of a default to minimize losses.
All of these metrics are designed to help the lender make good decisions, but none of these tell you as the borrower whether you really want to take the loan and whether it fits with your financial situation. Rather than relying on the lender’s metrics to help you understand your debt health, you might want to find another metric designed for you.
Enter the Debt Score
The Debt Score was created by savvymoney.com to help users understand their debt health, based on life stage, income, education, and other factors. Debt Score starts with the Debt-to-Income metric used by mortgage lenders for years to calculate your “borrowing capacity”, or the amount of your monthly income you can afford to pay for housing and other debts. The traditional rules of thumb state that no more than 28% of your monthly income should be dedicated to housing expenses and no more than 36% to total obligations including housing, credit card, auto loans / leases, student debt, etc.
Although DTI’s inclusion of income levels into the calculation make it a better measure of debt heath than credit score, it still doesn’t attempt to factor in your age or other goals.
How Debt Score measures your debt health
Debt Score builds on the “capacity” concept used by DTI, but makes 3 critical adjustments:
Age: Your age is a vital element in determining how much debt you should have. If you want to retire and save for the future, you’ll need to pay off credit cards, student loans, auto loans, and eventually your mortgage. Since paying 4% of your income to credit card debt might be OK when you’re 32, but not when you’re 64, you’ll want to use a metric that accounts for that. The DebtScore models how much debt you should pay off by type of debt depending on your age. Since mortgage debt is longer term debt, it may take several years to pay it off and it may not be paid off until you’re in your 50s or 60s. Credit card and other short term debt should be paid off much sooner in life so that you can move out of debt and start building assets.
Income growth: If you’re in a profession where your income will grow at 4% per year, you’re in a better position to manage a certain level of debt payments than another person whose income is likely to only grow at 2% per year. Your income will grow faster and reduce the debt burden. Debt Score factors in historical income growth based on historical trends.
Student debt: College is an investment that can increase your earnings but increases your debt burden. Because of the impact on earnings, a college graduate may be able to afford the higher debt payments coming from student debt.
How Debt Score is Calculated and Reported
Your Debt Score is calculated by comparing your debt payments to your monthly income and is reported as both a raw score and graded result.
Raw scores: Your raw score is simply the percentage of your income that you spend of different debt / obligation categories.
Graded results: Your graded results are shown for each category based on a proprietary scale based on your income growth, age, and education level. Your Debt Score report card may look like the following:
Get your Debt Score and improve your debt health today by clicking here for the Debt Score calculator.