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Since debt-to-income ratio (dti) is an important factor in determining one's creditworthiness especially for mortgage rates, it is clear that one should keep the monthly recurring debt and credit card payments as low as possible.

My question is: Would spending one's cash instead of using credit cards impact this rate? Let me give an example.

Say my gross monthly salary is $5000. My rent is $1000, monthly auto loan payment is $100, and for simplicity, I have no other recurring payments. Say my other living expenses (groceries, entertainment, dining etc) add up to $2000 and I am definitely living below my means. The question is: What happens if:

a) I spend that $2000 with my credit cards and pay my cards in full vs
b) I spend that $2000 with my debit card/cash?

Does option a make my dti (1000+100+2000)/5000 = 62% and option b (1000+100)/5000 = 22%? Is it this simple? Even though the money going into and coming out of my bank account remains the same, can just the method of spending make such a huge difference?

  • Are insurances part of the expenses? – mootmoot Sep 16 at 12:43
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If you're thinking of buying a home, don't use your rent in the calculation. Use the expected mortgage payment (plus PMI, insurance and taxes).

Also, while the $2000 is a debt, the bank only looks at the minimum payment (which in your case would be $40-$60).

So, keep on using your CC, paying it off every month and living below your means.

(Since the $2000 is for monthly expenses that you pay every month, using the CC as a convenient method of payment instead of necessity because you're living beyond your means, don't consider it debt. (Yes, technically it is, and will be treated as such if you don't pay it, effectively it's not, since you pay it every month. To drive that home, start paying the card at the end of the calendar month in which you made the purchases instead of on the due date.)

  • The bank might look at the debt, but a $2000 debt is trivial in the context of buying a house. Now if it was a $2000 monthly payment on a debt, that would be different. – jamesqf Sep 16 at 17:08
  • @jamesqf What do you mean by "a $2000 debt is trivial in the context of buying a house"? – FatihAkici Sep 18 at 3:59
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    @FatihAkici: I mean that (at least in most parts of the US) a house purchase will be several hundred thousand dollars. In that context, having a credit card balance of $2K or so, especially if it's paid in full each month, is almost expected as normal living expenses. – jamesqf Sep 18 at 17:22
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This question is hard to answer because it depends on the mechanics of the credit reporting process, and the timing of that $2,000 hitting the credit card throughout the month. It's important to understand these mechanics in order to answer your question.

Lenders report accounts to credit bureaus, including balance and minimum payment due. The balance impacts your credit score (via utilization ratio) and the minimum payment due impacts your DTI (which is not on your credit report, but lenders will use the reported minimum payment to calculate it when you apply for a loan).

Your card balance goes up as you use it, and down when you pay it. Your lender reports to the credit bureaus on a given day(s) each month, which may not line up with your statement. If the loan is reported with a high balance, it will effectively look like that debt is just sitting there, even if you are paying it off fully every month.

Let's look at two subtly different versions of your first scenario. Assume you start the month at $0 balance on the credit card:

  • You charge up that $2,000 early in the month. Your bank reports in the middle of the month, so your credit report shows you have a $2,000 balance, and a $100 minimum payment (made up number). Then, you get your statement, and pay the $2,000 in full.
  • Your bank reports in the beginning of the month, so your credit report shows $0 balance and $0 monthly payment. Then, you rack up $2000 during the month, and pay it off when you get your statement.

Even though, from your perspective, these two situations might be the same (you put $2,000 on your credit card throughout the month and then pay it off in full), they show up very differently on your credit report. In the first scenario, your credit score will be lower, and your DTI will be higher.

Unless you understand this timing carefully, and know how to "work the system" (i.e. by making sure you carry a low balance on the report date for your account), you are better off by leaving your card at or near zero balance and using your debit card, or cash, for regular expenses during periods where you are sensitive to credit score and DTI ratio.

  • What does credit score have to do with DTI? – RonJohn Sep 16 at 14:59
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    @RonJohn: Both score and DTI are calculated from the credit report, so "credit score tricks" like gaming payoff vs reporting dates will benefit the DTI calculation also. – Ben Voigt Sep 16 at 17:56
  • Thanks for the thorough answer! I am sure many others who have the same question is going to benefit from your answer tremendously. – FatihAkici Sep 18 at 4:00
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Your question is based on a faulty assumption:

Since debt-to-income ratio (dti) is an important factor in determining one's creditworthiness especially for mortgage rates,...

Debt-to-income ratio is not directly related to one's credit worthiness, and also is not relevant for your credit score. For example, even someone with no income at all could still have a very high credit score.

In general, your credit score helps determine your mortgage interest rate (the better your score, the lower your rate). Once your rate is determined based on your score, the DTI is used to calculate the maximum amount of mortgage you can afford.

Most mortgage rates bottom out when your score is in the range of 740-780. (Once your score is higher than that you won't get a lower rate.) If your score is below that range and consequently you won't receive the best interest rate, you may be able to make some minor tweaks to your spending habits to bump your score into the better tier. Note you only need to do this 1 month before you apply for the loan, and only need to continue doing it until the loan closes.

Regarding the situation you described of spending $2K from your debit card instead of your credit card, this might be helpful if you are not in the best tier of interest rates AND if your total revolving credit is low AND if your CC is reporting the $2K as your current balance. But the reason it helps is not due to DTI, but instead utilization percentage, which makes up 30% of your credit score calcuation. If your total overall revolving credit is $4K, and at the moment your CCs report you have $2K in utilization, your percentage will be 50%. Going from 50% to 0% will certainly bump up your score, and possibly put you into a better tier for mortgage interest rates during the month you do this. But if your revolving limit is $20K, your utilization percentage would only be 10%, and knocking that down to 0% probably won't bump your score very much.

As for DTI, the difference between $2K and $0 on a CC probably only affects your minimum payment by about $50-100, so that is likely negligible in changing how much mortgage you can afford (say $10K in additional mortgage, and if you're already that close to your affordable limit you are likely buying too much house).

All that being said, you did manage to back into a mostly correct conclusion:

...it is clear that one should keep the monthly recurring debt and credit card payments as low as possible.

This might help you for the reasons listed above, but you don't need to do this on a regular monthly basis, only about 1 month before you apply for the loan, and then only until the loan closes and the funds are disbursed.

Tip: instead of using your debit card or cash, you could also find out what date your CC reports on, and just make your pay-in-full payment a few days before that, and then you essentially accomplish the same thing but still reap the benefits of whatever CC points/cashback you may have.

  • Thanks for the thorough answer! I am sure many others who have the same question is going to benefit from your answer tremendously. – FatihAkici Sep 18 at 4:02
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What happens if:

a) I spend that $2000 with my credit cards and pay my cards in full vs

b) I spend that $2000 with my debit card/cash?

Rationally, they are the same, and some credit card like cashback rebate may give you an extra discount, zero-interest-rate instalment, etc.

HOWEVER

If you think again from the economist point of view on the spending ratio, you will notice the total expenses are 62% of the income, a high expenses-ratio. Apparently, you have a different mental accounting that make you think you are living below your means. Not unless if those living expenses including insurance.

A person may use different monthly budgets for grocery shopping and eating out at restaurants, for example, and constrain one kind of purchase when its budget has run out while not constraining the other kind of purchase, even though both expenditures draw on the same fungible resource (income). (Cheema, Amar; Soman, Dilip (2006-01-01). "Malleable Mental Accounting: The Effect of Flexibility on the Justification of Attractive Spending and Consumption Decisions". Journal of Consumer Psychology. 16 (1): 33–44. doi:10.1207/s15327663jcp1601_6)

By separating rent payment(20% income) with your monthly expenses (40% of income), you will not notice that you already used up 60% of your income. This may due to credit card spending behaviour that causes the decoupling. People will notice their rent payment, cash expenses, but will not notice how fast they spend the money when using a credit card.

You might say, you still have 38% of the remaining income. But once you reserved 15% for saving, 10% for insurances, there isn't much room for investment.

Here is my suggestion,

  • Try to use cash/debit card for two months. Look back at your expenses afterwards. OR

  • Plan your saving, insurance and investment.

  • 2
    You're assuming that insurance isn't in the $2000. – RonJohn Sep 16 at 12:32
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    It is much harder to track spending when using cash. Use the credit card and review the statement at the end of the cycle (even better if your bank provides a budgeting tool that automatically categorizes expenditures). Insurance most likely is on the credit card, because that's the most convenient payment type most insurance companies accept. – Ben Voigt Sep 16 at 17:59
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    Also, "total expenses are 62% of income" is a problem if that is gross income (there's nothing left after taxes). But if it is 62% of take-home pay, with taxes, health insurance, and retirement savings already taken out, that definitely qualifies as living within one's means. Finally, "once you reserved 15% for saving there isn't much room for investment" is making a meaningless distinction. – Ben Voigt Sep 16 at 18:02
  • @BenVoigt Unfortunately, as learned by Behavior economist, the end of month statement will not curb individual spending behaviour, as I already mentioned, one will spend more because people wouldn't feels the cash departure: getrichslowly.org/… – mootmoot Sep 17 at 8:15
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    @mootmoot: That's a paper (bills) vs plastic (card) issue, not debit vs credit. And the record of where the money was spent is a much better tool for changing habits. Switching to cash gets you an instant benefit, but a small one and you can't go any farther. Reviewing where the money went is more work, but you can make much more dramatic changes that way. – Ben Voigt Sep 17 at 21:24

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