What is a Good Debt to Credit Ratio?

Your debt to credit ratio is also referred to as your credit utilization ratio. It is the percentage of the credit available to you that you choose to make use of. Whether you spend $3,000 of a $12,000 credit card limit or $600 of a $1,000 limit, the individual figures are less important than the ratio itself. It all comes down to how much you have available versus how much you choose to use.

The colloquial saying “your credit card has a limit, not a target” may come into play here. Just because you’ve been approved for a $12,000 limit, this doesn’t mean you can max it out without adversely affecting your credit score.

So what is the best ratio?

Logic may imply that the best ratio is zero, as this means you have no borrowings and a good grasp of your financial situation. Lending institutions, however, don’t like the zero figure. They prefer to see a minimal amount of credit as evidence that you can manage debt and make repayments.

In short, the best debt-to-credit ratio is as low as possible but not zero. To put some figures on it. FICO (Fair Isaac Corporation) recommends having a ratio of 30% or less. Keeping it under 8% will contribute to an excellent credit score. Bearing in mind, however, to always keep it above $10 and never have a zero ratio.

For example, let’s return to the figures in the first paragraph. Which will give a better credit score?

  • Option A: Utilizes $3,000 of a $12,000 credit card limit.
  • Option B: Utilizes $600 of a $1,000 limit.

It may seem that as you’re only borrowing $600 in option B, as opposed to $3,000 in option A, that the significantly lower amount of option B would give a better credit score. If we look at the ratios, however, this is not the case. The debt-to-credit ratio for Option A is a healthy 25% while the ratio for Option B is 60%, despite the lower amount borrowed.

This is a very simplified example of how important the ratio is. And it’s pretty easy to calculate your debt-to-credit ratio.

The FICO credit scoring method uses two different ratios to calculate your score.

  1. The first is to calculate it for a single credit card. Simply divide your balance by your available credit line. For example, if you’ve spent $500 out of a $2,500 limit, your debt-to-credit ratio is a healthy 20%.
  2. The second method is to figure out your ratio across multiple credit cards. For example, suppose you have three credit cards with limits of $1,000, $3,500 and $5,000. To begin, add these three amounts together to get your overall credit allowance. Then add the balance of all three cards together and divide by the first number.

Why Do I Need To Know This?

It’s a useful exercise to know your credit score, and make adjustments to improve it before applying for any lending. This can save time, financial anxiety, and disappointment.

Your debt-to-credit ratio accounts for 30% of your FICO credit score. The higher the ratio, the lower the credit score. If you know it needs adjusting, it can be a very effective way of improving your credit score.

Ways to Improve Your Credit Score

  • Pay balances before they’re due.
  • Increase your credit limit. While this may seem counter-intuitive, either applying for a further credit card, or increasing the limit on your existing one can lower the ratio. Note this only works if you don’t use any of the extra available credit.
  • Consolidate your balances onto one credit card. Credit agencies usually note the number of credit cards bearing any balances. If you have small amounts owing across multiple cards, clear them by moving them onto one card. This is only effective as long as the resulting ratio on the card bearing the remaining balance will fall under 30%. Be sure to keep your zero balance cards active to maintain the low ratio and maintain the age of your overall credit history.
  • Make additional payments to bring the ratio under 30%.

Optimizing your debt-to-credit ratio is a process that will take time and commitment. If you’re serious about tidying up your financial affairs, achieving the right ratio will hugely improve your financial picture.

Leave a Reply