What Is Recurring Debt?
Recurring debt is any payment used to service debt obligations that occur on a continuing basis. Recurring debt involves payments that cannot be easily canceled at the payer's request, including alimony, child support, and loan payments.
- Recurring debt is any payment used to service debt obligations that occur on a continuing basis, including alimony or child support, and loan payments.
- Financial obligations are labeled as recurring if they must be paid at fixed, regular intervals and cannot easily be terminated.
- Recurring debt is used by creditors to determine debt-to-income (DTI) ratios.
- A borrower’s income is compared to the current amount of debt service payments to establish loan eligibility and interest charges.
Understanding Recurring Debt
Debt, simply, is a sum of money that is owed to somebody else. Sometimes debt is incurred without choice as part of a court order. On other occasions, it may be taken on voluntarily, giving individuals or companies the opportunity to borrow capital to purchase something they might not otherwise be able to afford under the condition that the sum loaned out is returned to the lender in full at a later date, usually with interest.
Financial obligations are labeled as recurring if they must be paid at fixed, regular intervals and cannot easily be terminated. Mortgage and car payments, child support, student loans, and minimum credit card payments all fall under this category.
Notable exceptions include bills that can be easily canceled, such as subscriptions. Credit card balances, too, are not counted as part of a consumer's monthly debt if the balance is paid in full every month.
Recurring debt is used by lenders to evaluate the creditworthiness of a potential borrower.
Lenders consider spousal support (alimony) and child support as long-term debt obligations when calculating eligibility for a loan. Lower monthly debt levels will generally improve an individual's credit score, allowing them to obtain lower interest rates, or borrowing costs, on lines of credit.
Impact of Recurring Debt
An individual's recurring debt is a strong factor when applying for a loan such as a mortgage. Used in the debt-to-income (DTI) ratio, lenders compare a borrower's income to the current amount of debt service payments. The DTI ratio is calculated by first adding up all monthly debt obligations, or recurring debt, such as car loans, student loans, minimum monthly payments on any credit card debt, and any other loan payments. The total is then divided by pretax or gross income and expressed as a percentage.
The concept behind this practice is to determine whether enough income remains, after accounting for recurring debts, for the borrower to comfortably fund monthly mortgage payments.
Types of Debt-to-Income (DTI) Ratios
Lenders tend to look at two different DTI ratios. The front-end ratio, also known as a household ratio, is the total amount of home-related expenses — the proposed monthly mortgage, property tax, insurance, and homeowners association fees — divided by monthly gross income. Lenders generally prefer this ratio to be 28 percent or lower.
In contrast, the back-end ratio includes all debts paid each month, such as credit cards, student loans, personal loans, and car loans, along with the proposed household expenses. Back-end ratios are usually slightly higher, typically 36 percent or lower, since they take into account all monthly debt obligations.
Most lenders prefer to see a debt-to-income (DTI) ratio no higher than 36 percent.
Having recurring debt, believe it or not, can help to improve an individual’s credit score. Those with existing or previous financial obligations might secure cheaper borrowing rates because they already have a track record of managing and paying off what they owe.
The amount of recurring debt must be reasonable, though. Taking on too many recurring payments at once increases the risk of defaulting on obligations. Missing payments has an adverse effect on credit scores and can lead to assets being repossessed, or in the case of child support payments, potential jail time.