Credit Scores: What is Debt Ratio?

| April 25, 2010

First let’s start by saying that your debt ratio is different from your debt to income ratio. Your debt ratio is the ratio of the amount of debt you have outstanding to the total amount of debt you have available to you. The lower your debt ratio, the better it is for your credit rating and FICO score.

Let’s use Suzie’s Debt as an Example:

Suzie has 3 credit cards, each with a limit of $1,000. Because of a series of unexpected emergencies, Suzie had to max out two of her credit cards, so she currently is using $2,000 of her available $3,000. That means that her debt ratio is as a result of her emergencies is now 66%.

From a credit/lending standpoint, that’s considered a high debt ratio. Lenders prefer to see a debt ratio of 50% or lower (the closer to 35% or lower the better). Lenders view high debt ratios as a sign of potential financial trouble.

Lesson Learned:
Work to lower your credit balances to 35% of the available limit or lower.

Lowering the Debt Ratio

Suzie realizes that maxing out her credit cards is not a good thing so she begins to lower her balances. Suzie is smart, but she makes one big mistake. In an attempt to curtail her credit spending she decides to close out the one credit card that has a zero balance. Her thought is that if she doesn’t have the credit available to her, she won’t use it and dig her self into a further credit hole.

Unfortunately, what Suzie did with that one move of closing out her one available credit card is she increased her debt ratio from 66% to 100%. She dropped her available credit to $2,000 (the exact amount she owes) and increased the percent of the amount of available credit used.

Lesson Learned: Do not close accounts with zero balances. They help to improve your credit profile.

Types of Accounts Included in Debt Ratio Calculations

When working to lower debt ratio, understand that only revolving accounts are included in the calculations. Accounts like credit cards, home equity lines of credit and other accounts where you have a revolving credit balance go towards your debt ratio calculation. Installment loans, mortgages and other types of accounts where you may not access the available balance after making a payment are not included when calculating debt ratio.

Cumulative Lessons Learned:

1. Pay your bills on time
2. Keep your debt ratio low

Tags: , ,

Category: Credit

About the Author ()

Felicia A. Williams is a wife, mother, freelance writer and owner of Tidbits About Money.

Comments are closed.