When you consider the factors that make up your credit score, some are easy to understand, and others not so much.
It’s easy to understand why potential creditors would be interested in your payment history. It tells them how reliably you’ve paid bills in the past, and helps them predict how likely you’ll be to repay new debt. And length of credit history tells them how much experience you have managing credit.
However, the significance of a debt to credit ratio might be harder to grasp. After all, “ratio” sounds like math, doesn’t it? Actually, it’s very simple.
In terms of your credit report, a debt ratio basically measures how much of your total available credit you’re actually using at any given time. Essentially, your goal is to have a lot more credit available than what you actually owe.
Understanding Your Debt to Credit Ratio
Consider this comparison:
Tom has a combined credit limit of $20,000 on four credit cards. Mary has a total limit of $10,000 on two cards. Tom carries a balance of about $10,000 on his card, and Mary’s balance is $5,000. Who has the better debt ratio?
Actually, their ratios are the same because both are using 50 percent of their available credit. While other factors may cause their credit scores to vary, for the purposes of evaluating their debt ratios, they’re on equal footing, even though Tom’s credit limit is higher.
Now what if Tom owed $19,500 and Mary still owed just $5,000? Tom’s ratio would be lower because he’s using much more – nearly all – of his available credit. That means his credit score could also be lower than Mary’s, even though he’s qualified for more credit than she has.
Why Your Debt to Credit Ratio Matters
Your overall debt ratio – how much you owe compared to how much is available – is an important indicator of your overall financial health. And creditors will view your debt ratio as a window into your creditworthiness.
Borrowing money means you have to repay it with interest. If the principal of what you owe nearly matches your income, you may have difficulty paying the interest on your current debt. Seeing a high debt ratio can alert creditors that you would have a hard time repaying new debt.
A high debt ratio may also make lenders and other creditors question your credit management skills.
Finally, using too much of your available credit can lower your credit score, making it difficult to secure new credit at favorable rates.
Fortunately, improving your ratio is not difficult. Simply pay down your current debt before you try to open any new credit accounts. Once your ratio (and score) improves, creditors will be more inclined to give you new credit – something which will also help improve your ratio by increasing your available credit.