Debt Ratios: What They Mean
When it comes to debt, there are all sorts of numbers that get thrown around. Interest rates, credit scores, fees. It can be dizzying. There are two terms that sound similar to each other and are often confused, but which are nothing alike. Those terms are debt-to-credit ratio and debt-to-income ratio. Let’s take a look at these two terms and see what they’re all about.
Debt-to-credit ratio looks at the relationship between the total amount of credit you have been offered, also known as your credit limit, and the amount of money you’ve borrowed so far. Basically, it’s the percentage of credit that you’re using. For example, let’s say you have a credit card with a limit of $2,000 and you’ve charged $500 on that card.
$500 / $2,000 = 0.25 or 25%. Your debt-to-credit ratio is 25%.
You can calculate this number for your total amount of debt (add up the balances on all your cards) compared to the total amount of credit (add up all the limits on these cards). Divide debt by the limits and you’ll have your debt-to-credit ratio. You’ll sometimes hear this referred to as a debt utilization ratio and, now that it’s been explained, it’s easy to see why. It’s a number to represent how much debt you’ve used.
How much does this number matter? Quite a bit, actually. This number is used as part of the calculation to determine your credit score can make up as much as 30% of your score. Experts estimate that you should strive to use no more than 30% of your available credit. If your ratio number is over 30%, working to pay down that debt can have a significant impact on your credit score.
Your debt-to-income (DTI) ratio is a completely different thing. First, it’s important to note that this number does not affect your credit score, but it can affect your ability to get a loan. This number looks at how much overall debt you have compared to how much money you earn. To figure this number out, you’ll need to look at all your regular, monthly recurring debt. Think about things like housing payments, car loans, student loans, minimum monthly payments on credit cards, and any other loans you have outstanding. Then, divide this number by your gross income, that is your income before taxes and other deductions. For example, imagine your gross income is $5,000 per month, and your rent, car, and credit card payments add up to $2,000 per month.
$2,000 / $5,000 = 0.40 or 40%. Your debt-to-income ratio is 40%.
Put another way, your debt uses up 40% of your gross monthly income. This number is used by lenders to determine whether they will extend a loan to you. If a larger percentage of your income is already accounted for – meaning you have little wiggle room in your budget – lenders may be concerned that you’re over extended and decline to offer you another loan. While each lender has a different threshold, the lower your DTI, the better off you’ll be. Aim for less than 35%, though 20% is better.