Why You Need to Know Your Debt to Credit Ratio

Debt debt-to-credit-ratio-hero

A good credit score can help you achieve important financial milestones, like getting a new car or buying a house. A key component of your credit score? Your debt-to-credit ratio.

Your debt-to-credit ratio is the amount of debt you have compared with your total credit limit. You may also hear this called your utilization ratio. These both mean the amount of available credit that you are using. A lower ratio boosts your credit score, while a high ratio can negatively impact your score.

Learn more about your ratio and what an ideal debt-to-credit ratio is. When you show potential lenders that you’re a responsible borrower, you’ll have more financial opportunities.

What is Debt to Credit Ratio?

Your debt-to-credit ratio is the amount of debt you owe compared with your available credit—usually expressed in a percentage.

For instance, if you have a total credit limit of $10,000 (with all of your credit cards combined), and you owe $3,000, your debt-to-credit ratio is 30%. In other words, you are using 30% of the total credit available to you. As another example, if your available credit is $50,000 and you have $10,000 in debt, your debt-to-credit ratio is 20%. Even though you have more debt in the second scenario, your ratio is lower since you have a higher credit limit. Your debt-to-credit ratio might also be referred to as your credit utilization rate.

A low debt-to-credit ratio indicates that you make purchases on credit responsibly. You don’t overextend yourself and are likely to pay off the debt you have. It shows lenders that you are trustworthy. A high debt-to-credit ratio, on the other hand, tells lenders that you spend your credit more liberally and might have a harder time paying it off.

What is a good debt-to-credit ratio? In general, financial experts recommend a debt-to-credit ratio of 30% or less. This indicates that you are spending credit responsibly—not maxing out your credit cards or failing to pay on time because you’ve overspent.

In fact, credit card limits are there for a reason. Based on your income and credit history, creditors grant you an amount they believe you can reliably repay. If you approach these limits, repayment might be more difficult because you are spending more than you can repay. Some creditors will increase your credit limit after showing that you are a trustworthy borrower.

How Your Debt to Credit Ratio Affects Your Credit Score

Although it’s a secret exactly how credit scores are calculated, there are some key factors that are considered. Your debt-to-credit ratio makes up 20% of your VantageScore and is a large component of the FICO scoring system as well. In other words, it’s pretty important.

Lower debt-to-credit ratios are associated with higher credit scores. For example, consumers with FICO scores of 800 or higher use about 7% of their available credit. However, an ideal debt-to-credit ratio is anything below 10%. Anything below 30% is considered good, but 30% shouldn’t be your target. You should aim to keep your debt-to-credit ratio as low as you can because it indicates that you’re paying lenders on time and not carrying high balances over from month to month. A higher rate, on the other hand, can flag potential lenders that you have difficulty managing your finances.

Not only do you want to keep your overall debt-to-credit ratio low, but on your individual credit cards as well. For example, you don’t want to max out a credit card to its limit. You want to spend a percentage—ideally 10% or less—of your available credit on each card, so you can repay the debt responsibly. A creditor doesn’t want to see you hitting the limit, because it’s unlikely you’ll be able to repay on time.

How to Calculate Your Debt-to-Credit Ratio

When calculating your debt-to-credit ratio, focus primarily on your credit card debt. The ratio is almost entirely made up of your revolving debt, not other debts like your student loans or mortgage. The creditors are more interested in your revolving credit—which is the amount you spend and pay off each month. Your other debt, like your mortgage and auto loan, factor into your credit score differently.

The debt-to-credit ratio formula is straightforward. Total up your credit card balances across all of your credit cards. Divide the balance by your total available credit. Convert it to a percentage to get your debt-to-credit ratio.

For example, Jamal has two credit cards, one that he owes $1,500 on and one that he owes $1,000 on. His total credit card debt is $2,500. If his limits on each of the cards are $5,000, his total available credit is $10,000. He would divide $2,500 (credit card debt) by $10,000 (credit limit) for a 25% debt-to-credit ratio.

You can also calculate the debt-to-credit ratio for each credit card by dividing your balance by your available credit line. If you spent $600 out of a possible $3,000 this month, your debt-to-credit ratio is 20% for that card.

As you aim to keep your debt-to-credit ratio low, your credit score will remain strong. Continue building your credit to boost your score and credit history. A better credit score can help you achieve your financial goals, whether that’s purchasing a new vehicle or getting approved for a mortgage.

Sources: Smart Asset | The Motley Fool | USNews | Experian

Tags:

Leave a Reply

Your email address will not be published. Required fields are marked *