Your credit score is a product of a number of different factors, and your debt to credit ratio figures prominently in the mix. The ratio gives lenders a picture of how you manage the repayments on your existing credit accounts and loans, and your ability to handle a new repayment obligation. A healthy debt to credit ratio makes obtaining new credit easier and cheaper.
Debt to Credit Ratio Explained
Your debt to credit ratio, also sometimes called your credit utilization rate, compares the amount of debt you have to the amount of credit you have. The ratio demonstrates how much of your available credit you are using. For instance, if you have one credit card with a $500 limit, and you have a $250 balance on the card, then your debt to credit ratio would be 50 percent, since you are using 50 percent of your available credit. As you either charge more on the card or pay down the balance, your ratio shifts accordingly. Likewise, if you obtained and used more credit, such as getting a loan or getting a new credit card, the ratio would also change to reflect your new situation.
Lenders pay attention to your debt to credit ratio because it can indicate current or future financial problems. If your debt to credit ratio is high, that is, if you are using a large amount of your available credit, it suggests to lenders that you are either relying too heavily on credit to meet your financial obligations, or that you are not managing your finances in a way that makes paying off debt a priority. On the other hand, a low credit to debt ratio demonstrates a healthy financial picture.
Advice about the ideal credit to debt ratio varies widely. For instance, Kiplinger and Bankrate recommend keeping that number down to below 30 percent, while Experian’s Consumer Info suggests anything below 75 percent is fine. Of course, individual lenders have their own guidelines in mind. Some banks want to see a ratio well below 30 percent before giving out a loan, while some credit card companies take a chance on someone with a load of over 75 percent. The bottom line is that you should keep the ratio as low as possible, according to the Fair Issac Organization, commonly called FICO, the group behind your credit score.
Benefits of a Low Ratio
When your debt to credit ratio is low, getting any kind of loan is easier, as lenders will see you as someone who can handle the repayments. A low ratio also makes loans and credit cheaper because it helps net you the lowest possible interest rates. With a high debt to credit ratio, expect getting loans and credit cards to be difficult, and expect to face high interest rates on any new credit that is extended to you.
Lily Welsh is a freelance writer from North Carolina, though she has spent much of her adult life living abroad. She is the About.com Guide to Music Careers, and her work appears frequently in other Web-based and print publications. Welsh has worked in the music industry for 15 years and counting and holds B.A.s in international studies and economics.