What Is Debt to Credit Ratio and How to Calculate? (2024)

It is widely known that credit cards can make shopping a breeze, but if you’re not cautious that breeze can turn into a wind storm of debt that carries exorbitant interest rates. What is often not so widely known is that how much you charge on those cards – even if you pay the full amount due each month – can affect your credit score. Specifically, how close your charges get to the credit limit on a card can compromise your credit score. Here’s what you need to know about that dynamic.

Work with a financial advisor to help you see how utilizing credit works with your overall financial plan.

The Meaning Behind Your Credit Utilization Ratio

Whether the credit line for your credit card is $2,000 or $10,000, that number wasn’t made up out of thin air. When you applied for the card, your lender likely looked at your financial background and assigned you a credit limit based on your income, your credit score, bankruptcy risk and your debt-to-income ratio (your total monthly debt payments relative to your income).

However it was decided, your credit limit is an important number to know. If you “max out” your credit card this means you spend up to the limit. When this happens, you will likely see the impact on your credit score.

Your credit utilization ratio is the percentage of your available credit that you are using (your credit card debt divided by your credit limit). You might be under the impression thatyou’re free to spend up to the limit without experiencing any adverse effects. We hear you saying, “My credit card issuer said I can spend up to $6,000.It’s OKif I max out my card this month, making student loan payments or taking care of themortgage loan on my house…right?” Nope.

Your credit utilization ratio (also known as your debt-to-credit ratio or your balance-to-limit ratio) is one of the factors used tocompute your credit score. A higher ratio means a lower credit score.

How YourDebt-to-Credit RatioAffects Your Credit Score

Your FICO® credit score is made up of five main components and each one carries a specific weight within the total score. How you’ve dealt with debt and made payments in the past accounts for 35% of your score. The number and amount of new credit accounts you’ve opened as well asthe different types of debt you have (credit cards, student loans, auto loans, etc.) each make up 10% of your score. The length of your credit history accounts for 15% of your credit score.

Finally, your debt-to-credit ratio and how much debt you carry together account for 30% of your FICO® score. All of this means that you might want to steer clear ofyour credit limit. It’s best to have as low a credit utilization ratio as possible.In short,ahigh debt-to-credit ratio candrive down your credit score.

Note that the FICO® scoring model calculates two different credit use ratios. One is based on yourdebt-to-credit ratio for each credit card in your wallet. The other adds all of these numbers together to show you how much you’ve spent in total relative to all of your credit lines.

Credit cards in particular matter to the threecredit reporting bureaus. Otherforms of debt that you might hold won’t have the same impact on your credit score. Since credit cards allow you to carry revolving balances that don’t need to be paid in full each month, credit cards carry more weightin the “amounts owed” section of your credit score than do debts from other loans.

How to Calculate Your Debt-to-Credit Ratio

The formula for calculating your credit utilization ratio is pretty straightforward. To figure it out for an individual card, divide your credit card balance by your available credit line. If you’ve only got one credit card and you’ve spent $400 out of a possible $2,000 this month, your debt-to-credit ratio is 20%.

But say you have three credit cards with credit lines of $1,000, $3,500 and $5,000. You can find your overall credit utilization by first adding those numbers. Then, divide your total balance across all three cards by the sum of your credit limits. If you have a $200 balance on each, your debt-to-credit ratio would be a little over 6% ($600 divided by $9,500).

What’s the ideal debt-to-credit ratio for credit cards? FICO® suggests that a good debt-to-credit ratio percentage is below 30%. And that goes for your ratio on any one of your cards separately as well as for your overall ratio.

How to Lower Your Credit Utilization Ratio

There are several steps you can take to keep your utilization ratio low and credit score in tip-top shape. It’s best to keep an eye on your credit card balances so that you’re not racking up too much debt. Your credit card issuer may be able to send you mobile alerts whenever your balances rise too high.

You might also want to try raising your total credit limit by requesting a credit line increase. This could be worth considering if you’re having a hard time keeping your utilization ratio under 30%. But increasing your credit line could cause your credit score to dip, especially if you spend too much money and you can’t pay your credit card bills.

Bottom Line

Just because you can spend a certain amount with your credit card doesn’t mean that you should. In fact, it’s a good idea tostaywell below a 30% debt-to-credit ratioso your credit score doesn’t take a hit that’ll keep you from buying a houseor refinancing an existing one. The lower your credit utilization ratio, the better.

In addition to keeping your spending in check, you can also lower your credit utilization ratio by increasing your credit limit. If you haven’t asked for a credit line increase in six months or more and your income hasn’t decreased, your credit card company will likely agree to raise your credit limit. But if increasing your credit limit will just tempt you to spend more, it’s important to be wary of that strategy.

Tips for Borrowing Money

Photo credit:©iStock.com/pidjoe,©iStock.com/AsiaVision,©iStock.com/wichayada suwanachun