Debt to income ratio and credit utilization ratio; why do these two things matter and what do they mean? Both can impact what kind of loans or credit cards you are approved for, but only one will affect your credit score. Nevertheless, they are both used as indicators to creditors looking to determine whether or not you are able to take on additional financial obligations. Therefore, both of these should be taken into consideration when creating your financial plan.
Debt to Income Ratio
Your debt to income ratio (DTI) is calculated by dividing the total amount of your monthly payments by your gross monthly income. This will tell you what percentage of your monthly income is used to pay your monthly debt payments. For example, if your recurring monthly debt is $2,000 a month and your gross monthly income is $6,000, your DTI would be $2,000 ÷ $6,000 = 0.33 or 33%.
While DTI is not a factor taken into account for your credit score, lenders will look at this percentage to assess whether or not a borrower is able to repay a loan. A high DTI may indicate that the borrower would be overextended if they incurred additional monthly payments.
Before applying for a loan or new line of credit, it is good to calculate your DTI and if it is above 40%, find ways to improve it. There is no magic number for what lenders and creditors will accept, as the threshold will vary. But, keeping it below 28% is a good goal. However, lenders may make exceptions depending on a number of factors, like the type of loan, the borrower’s credit score, savings, assets, and down payment may also come into play.
Credit Utilization Ratio
Your credit utilization ratio, also known as credit utilization rate, is calculated by dividing the amount of revolving credit you are using by the amount of revolving credit that is available to you. For example, if you have a total of $7,000 available to you in credit and owe $1,500 on your revolving accounts, your credit utilization ratio would be $1,500 ÷ $7,000 = 0.21 or 21%.
Keep in mind, according to the credit scoring models of the three major credit bureaus, your credit utilization ratio can impact up to 30% of your credit score and is one of the most influential factors. The quickest way to improve your credit utilization ratio and boost your credit score is to pay down your credit card balances. However, if you have the time, making consistent payments over a period of time, like 12 months, would have a greater impact to improve your credit score. Improving your credit utilization ratio will also help your DTI.
If you are trying to get approved for a loan or credit, these two factors not only have a significant impact, they are often the most feasible for you to work on. Another thing to be aware of is it can take some time for debt repayments to be reflected in your credit report. The key is to be patient and don’t expect to see results immediately. You can access your credit reports for free at AnnualCreditReport.com to see what is currently in your credit file from the top 3 credit bureaus, TransUnion, Experian, and Equifax.