Debt to credit ratio is the percentage of a consumer’s gross income that goes toward paying debts. It shows how much you are using the credit that is available to you, or rather, how heavily your finances lean on credit.
How is debt to credit ratio calculated?
Your overall debt to credit ratio (also called credit utilization limit) is calculated by dividing the total amount of debt by the total of your credit limits. It is also done for each separate account. High debt load in either category lowers your FICO credit score.
Debt to credit ratio = Debt used divided by available credit multiplied by one hundred.
For example, a debt of $4,000 on a credit card with an $8,000 limit = 50% . $6,000 on the same card gives a ratio of 75%.
The higher this ratio is, the closer you are to financial trouble. Creditors use it to examine your overall risk. The closer you are to being maxed out, the more of a risk you are to the creditor. It therefore affects your ability to obtain loans at favorable rates from financial institutions. It is advisable to keep your ratio as low as you can by working to pay off your debts. You can even use debt reduction services to help with this (assuming you go with a private loan).
How Much is Too Much?
Now that you have made your calculation, we need to answer the question “how much is too much?”. When applying for credit, the loan officer will check your debt to credit ratio as one factor in making a decision, though it will not be the only factor considered. The same credit utilization limit may be great for one family but may have a negative effect on another. Debt to credit ratios are a subjective tool for loan officers to make decisions about your ability to meet a new obligation. There are some general guidelines, however, that can give you a reasonably clear picture of where you stand in the eyes of a credit officer.
- Below 30% is generally considered as an excellent ratio by the wide majority of loan officers
- 20% to 36% is a good ratio and will most likely not cause any problems with loan officers or have a negative impact on your FICO score
- 36% to 40% puts you on the edge of acceptability. Most lenders will ask for an explanation for why your debt to credit ratio is so high. In addition, a debt to credit ratio in this range begins to have a negative impact on your FICO score so lenders look to other strong numbers before making a decision to loan more money to you
- Greater than 40% sends up red flags with lenders and your FICO score. Often, this high a ratio will be a deal killer with most lenders
By calculating your own debt to credit ratio you begin to get a handle on your own financial situation. If the ratio is too high it alerts you that you are too deep into debt and you must do something to lower debt. Of course, if it is very low then you don’t need to do anything.
Reasons You Need to Control Your Debt to Credit Ratio
Your credit utilization is what makes the difference between paying your bills every month or falling behind and into financial crisis. Loosely speaking, if you pay out nearly as much (or more) in monthly costs as you bring in, your debt to income ratio is certainly too high. As a business owner, it is important to pay attention to debt to credit ratio because it could have a significant impact if it gets out of control. Below are some of the reasons:
- You may not be eligible for the financing you need when you need it if you have a high debt to credit ratio. One of the ways many people have fallen into an unfavorable position is through credit cards. Poor management of credit cards and accepting every offer that comes your way will make your ratio jump through the roof faster than you’d ever expect possible.
- High ratios often lead to financial troubles. Financial problems are very stressful and taxing on people’s emotions. They are one of the key reasons that relationships end – both business and personal relationships.
- When a ratio is too high it will obviously be reflected in your credit score. Although credit score is not everything for business owners it is still important. Credit scores are key determinants of the rates that you will be offered and if you qualify for conventional financing. Conventional financing usually has the most favorable rates and terms. The higher the risk the higher the payment. The higher the payment the higher the debt. It is easy to see why you are best to just avoid getting yourself into a situation with an extreme debt ratio.
- It is easier to control your finances. When you have less debt you are less likely to forget to clear a bill or fall a little short of cash at the end of the month. Very few people enjoy paying bills and it is never fun. When you have to pay them while worrying about having enough money to do so makes bill paying a nightmare.
- When you need financing the approval process will be much quicker. Debt to credit ratio is one of the first factors a creditor looks at when making a decision to lend to you. Drawn out approval processes can often be time consuming, discouraging, and negative if you don’t get approved when all is said and done.
In order to be financially responsible you need to make the correct choices. Anybody who has come back from a large debt has probably warned you that it is not easy. They usually say, “It was far easier to get into than get out.” This is why it’s important to start managing your credit utilization limit, NOW!