Understanding the Debt-to-Credit Ratio and Its Impact on Your Financial Health
Managing your finances effectively is crucial for maintaining a healthy credit score and securing favorable loan terms. One key metric that plays a significant role in this process is the debt-to-credit ratio. In this blog, we will delve into what the debt-to-credit ratio is, how to calculate it, its impact on your credit score, and how it differs from the debt-to-income ratio. By understanding these concepts, you can make informed decisions to improve your financial health.
What Is the Debt-to-Credit Ratio?
The debt-to-credit ratio, also known as the credit utilization ratio, is a measure of the amount of credit you’re using on your credit cards relative to your credit limits at a given time. This ratio is a critical factor in your credit scores and is often considered by lenders when reviewing your application for a loan or credit card. Other terms used to describe this concept include balance-to-limit ratio and debt-to-limit ratio.
Your debt-to-credit ratio contributes to the “amounts owed” category of your FICO® Score, which makes up 30% of the score. A high ratio could indicate that you’re carrying high balances on your credit cards month to month, potentially only making the minimum required payment. This could increase the risk of you defaulting on debt payments, which presents a risk to lenders. As a result, you could be charged a higher interest rate on a new loan or credit card or even get an outright denial.
In contrast, a low debt-to-credit ratio could indicate that you manage your debt responsibly, which could increase your scores and cause lenders to view you as a safer borrower.
How to Calculate Debt-to-Credit Ratio
Calculating your debt-to-credit ratio is simple. Take each credit card you have and divide the balance by the card’s credit limit. Then, add up the balances and credit limits across all of your credit cards and do the same calculation to get your overall ratio. Credit scoring models consider both individual and overall ratios in scoring calculations.
For example, let’s say you have three credit cards. Here’s what the debt-to-credit ratio would look like for each one, as well as across all of the accounts:
| Card | Balance | Credit Limit | Debt-to-Credit Ratio |
|---|---|---|---|
| Card A | $2,500 | $7,500 | 33.3% |
| Card B | $1,000 | $2,000 | 50% |
| Card C | $2,000 | $10,000 | 20% |
| Total | $5,500 | $19,500 | 28.2% |
How Does a Debt-to-Credit Ratio Impact Your Credit Score?
The amount you owe on your debt accounts, including loans and credit cards, makes up 30% of your FICO® Score, and your debt-to-credit ratio is an influential factor in that category. Carrying high balances on your credit cards can have a significant negative impact on your credit score.
Some credit experts recommend keeping your debt-to-credit ratio below 30%. While this is a good rule of thumb for a ceiling, it’s by no means a goal for the perfect debt-to-credit ratio. The lower your ratio, the better it is for your credit score. Those with the highest credit scores typically have debt-to-credit ratios near 0%, and higher debt-to-credit ratios are generally correlated with lower credit scores.
Keep in mind, though, that your debt-to-credit ratio is just one of many factors that go into your credit score. Your FICO® Score, for instance, is most heavily influenced by whether you’ve been making on-time payments (your payment history). Other factors that affect your FICO® Score are the length of your credit history, whether you’re using different types of credit, and recent credit inquiries.
What’s the Difference Between Debt-to-Credit and Debt-to-Income Ratios?
Both the debt-to-credit ratio and the debt-to-income ratio can indicate how well you’re managing your debt but in different ways.
While your debt-to-credit ratio shows how well you’re managing your credit card balances, your debt-to-income ratio assesses how much of your income goes toward debt payments—that includes both revolving and installment credit.
For example, if your gross monthly income is $5,000, and you’re required to make payments that total $2,000 toward your mortgage loan, credit card minimum payments, auto loan, and student loans, your debt-to-income ratio is 40%. A high debt-to-income ratio could be a sign that you’re overleveraged and may have trouble affording another payment.
Another way the two ratios differ is that while lenders will consider both when you apply for credit, only your debt-to-credit ratio impacts your credit score because your income isn’t included in your credit score at all.
The Bottom Line
Your debt-to-credit ratio is an important indicator of your credit health, particularly in how you manage your credit cards. If you have a high ratio, it could be hurting your credit score and your chances of obtaining good credit terms.
Review your Experian credit report for free to get an idea of what your debt-to-credit ratio looks like. If it’s higher than you want it to be, take steps to pay down your credit card balances to reduce it. You can also monitor your credit score to track your progress and see how your efforts are paying off.
At O1ne Mortgage, we understand the importance of maintaining a healthy credit score and managing your debt effectively. If you need assistance with your mortgage or have any questions about your financial health, don’t hesitate to call us at 213-732-3074. Our team of experts is here to help you navigate the complexities of mortgage services and ensure you get the best terms possible.
