Debt…most Americans have it. On average, each American household with a credit card carries $8,398 in credit card debt alone. Factor in mortgages and auto loans on top of that, and it’s easy to see why so many people need to pay attention to debt to income ratio and debt to credit ratio.
While they sound similar, they’re two separate things, and they both directly or indirectly affect your credit score or ability to take out more lines of credit. Depending on which credit scoring model you use, your debt to credit ratio can affect your credit score. In contrast, your debt to income ratio can affect a lender’s decision on whether or not to approve a credit application.
Sound confusing? Don’t worry. We’ll help you sort it all out.
What is Debt to Income Ratio?
What’s the definition of debt to income ratio? It’s a ratio of your minimum monthly debt payments compared to your total gross monthly income.
Debt to Income Ratio = Monthly Debt Payments / Gross Monthly Income
For example, if you pay $300 a month in student loans, $100 for your car payment, and $200 for your credit cards, your total monthly debt payments equal $600. If your gross earnings are $5,000, your debt to income ratio would only be 12%.
Does this affect your credit score? Nope! Income isn’t one of the factors affecting your credit score, and you won’t find it on any credit report, either. However, lenders will usually calculate your debt to income ratio when deciding whether or not to approve your credit loan application. This is particularly true and important for larger loans, such as mortgage loans.
They’ll factor in your current amount owed, add the monthly minimum payment for the loan you’re trying to apply for on top of that, and then see your debt-to-income ratio.
What is a Good Debt to Income Ratio?
Typically, a great debt to income ratio is below 20%, but a good ratio is somewhere between about 35% to 38%.
If your debt to income ratio goes above 43%, you might find that you won’t be able to qualify for the types of loans or loan rates that you’d like.
If that’s the case, you’ll need to reduce your debt to income ratio by:
- Reducing your monthly debt (check out our debt payoff calculator)
- Increase your gross monthly income (try thinking about starting a side hustle)
What is Debt to Credit Ratio?
Now, let’s get into the definition of debt to credit ratio. It’s most commonly referred to as credit utilization rate, which is the amount of available credit you use each month.
Debt to Credit Ratio = Credit Balance / Credit Limit
If you have a $5,000 credit limit on one card and charge $1,000 on that card, your debt to credit ratio would be 20%.
Each card will have its own debt to credit ratio. If you have multiple credit cards or other types of revolving accounts, credit agencies will take all of them and combine them to calculate one overarching debt to credit ratio.
Because credit reporting agencies look at this when determining your credit score, it’s best to avoid charing large purchases to your credit card if you don’t plan on paying it off immediately. It’s important to truly pay attention to your credit utilization rate as it’s one of the biggest factors that affect your credit score.
FICO, for example, uses credit utilization to account for about 30% of your credit score.
What is a Good Debt to Credit Ratio?
The ideal debt to credit ratio is at or below 30%. This applies to the ratio on each of your cards and your overall debt to credit ratio.
Want to know how to lower your debt to credit ratio? Try downloading a budgeting app to help you budget your incomes and expenses better. Allocate more money toward paying down your unpaid debt and less towards unnecessary costs such as entertainment.
Monitoring Changes in Your Credit Score
As mentioned, your debt to income ratio doesn’t directly affect your credit score, but it can affect your ability to take out more credit. Your debt to credit ratio most certainly affects your credit score, making it something you’ll want to keep an eye on.
If you’re working towards improving your debt to credit ratio, it helps to monitor your credit score so you can stay motivated. To help with that, download Float. It allows you to access a frequently updated credit score and even share it with others.
Having the ability to share your credit score or credit range with others is a great way to increase accountability while making credit monitoring as fun as it can be. As you begin to learn how to improve your credit score, you’ll be able to share your wins with others.