When it comes to personal finance metrics, many important numbers are expressed as ratios. Two of the most common ratios you’ll hear are debt-to-credit and debt-to-income. They sound somewhat alike, so they’re easy to confuse.
So, what do these terms mean? What’s the difference? And how are they used? Let’s check them both out.
What is the debt-to-credit ratio?
Your debt-to-credit ratio, also known as credit utilization, has to do with revolving debts like credit cards. When you get a credit card, you’re given a certain credit limit. This is the “credit” portion of this ratio. As you spend on this credit card, racking up a balance, you go into debt to the credit card company. This balance is the “debt” portion of your debt-to-credit ratio.
Your debt-to-credit ratio can be expressed as a percentage. If you owe $100 on a card with a $1,000 limit, you have a 10% debt-to-credit ratio ($100 / $1,000) on that card.
You have a debt-to-credit ratio for each individual credit card or other revolving account, like a home equity line of credit (HELOC). But you also have an overarching debt-to-credit ratio that takes into account all of your credit limits and all of your balances.
The table below illustrates how these individual and overarching debt-to-credit ratios interact:
|Card||Balance||Credit Limit||Debt-to-Credit Ratio|
How is debt-to-credit ratio used?
Your debt-to-credit ratio directly affects your FICO score. Roughly 30% of your score is made up of your “credit utilization.” This is further broken down into things like debt owed on installment loans, total debt owed to lenders, number of accounts with outstanding debt, and the amount of money you owe on individual accounts.
The credit utilization category breaks down into smaller categories, some of which aren’t even related to your revolving loans. But your debt-to-credit ratio is a weighty portion of this category, and the lower you keep this ratio, the better your score will be.
The “ideal” debt-to-credit ratio is 0%, which means you never carry a balance on your revolving accounts. However, even bringing your ratio from 50% to 25% can have a huge positive impact on your FICO score.
Keep in mind that both sides of your debt-to-credit ratio — on individual accounts and on your revolving debt overall — will affect your credit score. Take the card balance scenario above, for example. The quickest way to bring up your score would be to pay down the second credit card, which has the highest debt-to-credit ratio. Paying down that one card would give you better individual debt-to-credit ratios, while bringing down your overall debt-to-credit ratio.
What is the debt-to-income ratio?
Your debt-to-income ratio doesn’t directly impact your FICO score, but it will affect your ability to borrow. This is one of the numbers lenders will rely on most when deciding how much mortgage you can afford, for example.
This ratio expresses the total of your monthly minimum debt payments compared with the total of your gross monthly income. So if you pay a total of $1,500 in monthly payments between your student loans, credit cards, and car payment, but gross $5,000 per month, your debt-to-income ratio is 30%.
How is the debt-to-income ratio used?
As noted above, your debt-to-income ratio doesn’t count toward your credit score at all. In fact, your income isn’t even part of your credit report or credit score. But lenders will nearly always look at this ratio before agreeing to lend you money, especially for a home.
Different lenders will have different debt-to-income ratio qualifications. In general, lenders like to see a debt-to-income ratio of around 36% to 38%, though 20% or below is considered really good. When your debt-to-income ratio gets past 43%, you may be unable to qualify for even a mortgage aimed at higher-risk consumers.
Keep in mind that lenders will calculate your debt-to-income ratio after including the minimum monthly payments on the loan for which you’re trying to qualify. So, if you currently have $2,000 in monthly minimum payments and are looking at a mortgage with a $1,000 monthly payment, the lender will calculate your debt-to-income ratio based on $3,000 of monthly payments.
What it all means
What do these ratios mean for you and your financial life? Basically, they mean the less debt and lower monthly payments you have — or the higher credit limits and larger income you have — the better off you’ll be financially. Keeping both of these ratios as low as possible is a good way to boost your credit score, stay solvent, and be ready to borrow when necessary.
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Read more: Self Lender ReviewTopics: Credit • debt