Credit utilization rates and debt-to-income ratios are two critical factors in a consumer’s ability to qualify for new credit. If you want a strong FICO score and great borrowing rates, it’s imperative to understand how these factors work.
AMOUNTS OWED (30%) – This Means Your Credit Utilization Ratio!
Do not avoid this topic … it’s literally the only variable with the power to change your score FAST!
Please take the time to read through this post, explaining how these ratios work and how they can be manipulated.
If you want your credit score to go up, this post will be as good as gold!
Let’s begin …
Your credit utilization ratio is the amount you owe to creditors versus the total amount you can borrow from them.
Here’s an example …
Card #1 — Balance: $750 , Limit: $1,500
Card #2 — Balance: $2,000 , Limit: $5,000
Card #3 — Balance: $0 , Limit: $3,500
Total Balance: $2,750 , Limit: $10,000
Utilization = $2,750 / $10,000 = 27.5% Credit Utilization
Your utilization ratio is calculated by counting the balance and credit limit for ALL revolving accounts. Installment loans, such as mortgages, are considered but do not hold as much weight. For calculation purposes, focus on your revolving utilization ratio first.
There is a direct relation between your FICO score and your utilization rate. Those who manage to maintain low credit utilization typically have good credit scores. The only exception was the case of 0% utilization rates, as these were often the result of inactive borrowing accounts. It’s hard to get ahead without any payment history to contribute towards the 35% of your score calculation.
This single factor makes up for 30% of your FICO score!
The current FICO scores that exist (yes, all 50-plus) work with the same calculation algorithm. They value your score, with 30% of the calculation coming from your credit utilization. This means it makes sense to increase your credit availability — even if that comes at the cost of opening new credit cards or asking for limit increases.
Your credit utilization will not be hurt as much from a higher utilization in installment credit accounts. This means you do not have to worry about a large student loan causing your utilization rate to be sky-high. If this were the case, the vast majority of Americans would not qualify for a home loan.
Your car loan, home loan, home equity loan, and student loan will not be weighed as significantly as your revolving debts — such as your credit cards and home equity lines of credit. As such, you should focus on reducing the ratio for your revolving credit accounts first.
That said, there’s one last confusion to air out about credit utilization:
“Debt-to-credit” is another term that gets used, as it easily explains how credit utilization works. This confuses as some interpret debt-to-credit and debt-to-income as similar. In reality, debt-to-income is a completely different thing. It does not impact your credit score.
If you hear ‘debt-to-credit,’ then they mean the same thing – credit utilization ratio.
You can have a utilization ratio between 30% and 40% as long as your income is sufficient. This range will prevent you from getting rejected for many decent credit cards, which can help you further build your credit. Although, you will not notice your credit score increase much until your utilization rate decreases. New credit availability does not help your score that much, but maintaining the improved ratio will pay off with time.
It would be best to target a utilization ratio of no more than 30% on all revolving credit accounts. While doing so, you do not need to focus on balancing your utilization rate between cards. Having a higher utilization on one card means little as it’s only your full ratio across the board that factors into your credit rating.
If you are buying a house, 28% or less would be a better target. The lower you can get it, the better. If you can get all your credit cards paid off, that would help a lot. As we’ve mentioned, these (and other revolving debts) play a big part in your credit score calculation.
The lower you can get your utilization ratio, the more strength you have when negotiating with a lender. It gives you a better shot at picking up excellent borrowing rates. Even better, you will qualify for much more when financing a new car or a home if you can drastically reduce these outstanding debts.
But, you could benefit from keeping utilization rates low all-around as your credit card issuers would be more inclined to offer you limit increases. These offers should be taken up as long as you trust yourself with more available credit — the result will be less credit utilization and a higher FICO score.
Your debt-to-income ratio is also a simple equation, as it looks at the amount of debt you have compared to the amount of recurring income you receive.
Things can get confusing fast when you analyze how this ratio gets calculated. It’s not actually about your outstanding debts, but rather your monthly debt payments; lenders want to know you can afford to pay off more debt each month.
Further, it’s not just your debts that matter — your recurring expenses will also be considered.
There are many types of debts and sources of income that factor into this equation. However, you must understand that some things are exempt, which could either be good or bad for your debt-to-income ratio.
What debts are considered for your debt-to-income ratio?
What income is considered for your debt-to-income ratio?
There are other types of income that might qualify, such as rental property income. It would help if you found out whether the lender is willing to consider your alternative income streams.
Unless you have a massive down-payment or valuable collateral asset, no lender will take you seriously with a poor debt-to-income ratio. It is the pivotal number that determines whether a borrower can afford to take out more debt.
This figure gets lined up next to the credit utilization rate — combining the two makes it easier for the lender to understand the worst-case scenario. When credit utilization gets factored in, they have a good idea of how much your monthly expenses would be if you maxed out your current available credit.
Here’s where people get confused.
When buying a home, people get shocked when they find out that their mortgage costs will get factored into their debt-to-income ratio. This has to happen because your expenses will no longer be the same.
There’s a catch: when buying a home for yourself, your “debt” part of the equation changes to accommodate the monthly housing costs you will soon face.
In general, your new home costs should make up to 30% of your monthly income. With all factored in, your target should be 36% or less.
The 28% figure affects your mortgage payment, taxes, and insurance. The higher percentage factor targets your housing costs and your debt repayments, and other expenses.
There are various ways you can bring down your debt-to-income ratio. For example, you can reduce your living costs before applying, or purchase a property with rental income, to smooth the ratio.
FICO scores, home loans, and everything in-between make the topics hard to discuss. There are countless variables at the lender level, and even more that vary by consumer. If you want to have the best chance for approval on any credit card or loan and first picks at the greatest rates and rewards, you need to master this subject.
We have extensive detailed posts relating to credit-building, credit reports, FICO scores, home loans, and more. If you are looking to boost your FICO score, we recommend starting with our post: ‘6 Tricks to Significantly Increase Your Credit Score with Credit Cards Only!‘ – also, check out our post explaining how FICO scores work if you are not familiar with them already.