Debt-to-credit ratio is one of the most important factors affecting your credit scores. This is often times more impactful than defaulting on small credit accounts or the amount of credit you have established. Carrying a large debt-to-credit ratio can damage your credit score (or FIFO) while you remain completely unaware.
What Exactly is a Debt-to-Credit Ratio?
Debt-to-credit ratio is determined by the amount of credit you possess versus the amount of debt you owe against it. For instance, you hold a credit card with a credit limit of $10,000, however, your debt against it is $8,000. This is a high debt ratio. In this instance, the credit bureaus would see you as a high risk and rank your credit at a lower score. To take this a step further, assume this credit limit is the total credit limit divided among three credit cards, and your total debt against it is also divided among three credit cards. Even if all three creditors receive timely payments, this could cause a tremendous negative impact to your credit. Creditors, often consider this “maxed out.” This is even more of an issue because it is spanned out over several credit cards, indicating that more creditors were needed to provide you with what you consider to be necessary credit.
It is, however, appropriate to maintain a small debt-to-credit ratio. The magic ratio number for creditors is typically 30%. However, some lenders would accept a 50% ratio. Creditors want to see that you are, in fact, using your credit, however, they do not want to see a debt -to-credit ratio above 30% to 50%. When shopping for items such as a mortgage or new vehicle, the lender would like to know that you have 50% to 70% of your available credit available for use at any time. This available credit indicates tot eh lender that you are not living beyond your means and that you are a good credit risk. Furthermore, this helps ensure that you will receive lower interest rates.
How Credit is Weighted
The credit reporting agencies assess a variety of factors when determining your scores, but some factors are given more weight than others. From MyFico.com:
- Payment History: 35%
- Amounts Owed: 30%
- Length of Credit History: 15%
- New Accounts: 10%
- Types of Accounts Used: 10%
Credit utilization is categorized in the Amounts Owed group, which, as you can see, is given a 30% weight when your scores are determined. Therefore, it is easy to see why the debt-to-credit ratio plays such a vital role in assessing credit. The only item more important, and not by much, is payment history. All other items are significantly less important factors in determining scores and credit risk.
As seen here, the debt ratio ranks very high on the list when determining credit worthiness. The ratio helps determine whether an individual maintains too much debt and is therefore a higher credit risk. The generalization is that a person deep in debt is a larger risk. This person may be unable to obtain a loan or may receive an astronomical interest rate with the loan.
How to Improve Your Debt-to-Credit Ratio
The most effective way to improve your ratio is to pay down your credit cards. By lowering the balances, you increase your available credit lines. It is important to keep these credit cards open as showing the payment history and open lines of credit will also help to increase your FIFO score. Once you have decreased your debt, creditors will see that you have a larger, untapped credit resource and determine that you are a viable credit risk.
While paying down your balances, you must keep in mind all aspects that creditors look for when lending money. Creditors like to see that you have a long history of credit. Therefore, if you are going to pay off and then close any credit cards, make sure they are the credit cards you have opened within the past year to eighteen months. Any credit cards opened prior to that time frame, should remain open. Furthermore, these older cards should be used monthly or bi-monthly and paid just as quickly.
While it is important to utilize credit cards to show a good and worthy credit history, it is just as important to keep your debt-to-credit ratio between 30% and 50%. As discussed above, this helps creditors know that you are not “maxed out” and you are a viable credit risk. However, do not expect the credit reporting agencies to be accurate at all times. Check your credit report regularly to ensure that all of the accounts actually belong to you and are accurate and in accordance with your records. As a consumer, you are entitled to one free credit report per year from each of the three credit reporting agency:
- Experian; and
It is recommended that you obtain one report every four months.