The next time you whip out your plastic to buy a new blouse or treat everyone to dinner, remember that it might come back to haunt you later when you’re looking for a mortgage or low-interest credit card. Lenders use your debt-to-income ratio for some loans, and your debt-to-credit ratio for others. Understanding the difference between the two and some target ratios will help you manage your debt and increase the chance you’ll get the credit you need.
One indicator of creditworthiness lenders use to evaluate you is your debt-to-available-credit ratio. This is the amount of debt you are carrying relative to how much credit you have available. Lenders might not know about all of your debt, such as loans from family or friends or business loans not reported to credit reporting agencies. The lower your ratio, the better a credit risk you are and the more likely you are to get a credit card, loan or low-interest rate on credit.
Your debt-to-income ratio compares your monthly debt payments to your monthly income. Lenders use income information you supply and credit information supplied by one or more of the three major reporting agencies, TransUnion, Equifax or Experian. Unlike with the debt-to-credit ratio, lenders don’t look at your total debt, but your monthly debt service instead. For example, two people might have the same amount of income and debt, but different debt-to-income ratios. One of the two might have a larger monthly car or mortgage payment or higher credit card balances and therefore, higher monthly debt service payments.
Target Debt-to-Credit Ratios
If you’re looking to open new credit card accounts, there’s no industry standard for debt-to-credit ratios, but many financial advisers recommend keeping your ratio to 25 percent or less if you want to receive the best card offers, including low-interest rates. Under this ratio, you’d keep your charges to $2,500 or less if you have $10,000 worth of credit. Closing a card you’re not using will increase your debt-to-credit ratio. Canceling a card with a $5,000 limit would raise your debt-to-credit ratio to 50 percent in the above scenario.
Target Debt-to-Income Ratios
If you’re shopping for a mortgage, Bankrate.com recommends targeting monthly mortgage payments to 28 percent or less of your gross income, and your total monthly debt-to-income ratio to 36 percent or less. The website recommends this common industry guideline to help people calculate how much of a home they can afford to buy using the same guidelines many lenders use to evaluate you. If you make $50,000 annually, your total recommended debt-to-income ratio is $1,500 per month, with $333 of that going to credit card, car loan or student loan debt, and $1,167 of that going toward your mortgage payment. Another common debt-to-income ratio cited by financial experts is 33/38. Use a debt-to-income ratio that lets you pay your monthly debt service and your other monthly expenses and lets you save for an emergency fund and retirement.
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