The credit-to-debt ratio, also called the credit utilization ratio, is a key metric that lenders analyze when considering a loan application. It's easy to calculate on your own, so you can do your homework before submitting a loan application. Obviously, low ratios are better: but some types of credit are better than others, and think twice before closing that credit card account you're not using.
Types of Credit
There are three types of loans: revolving, installment and open. A revolving loan has a monthly payment that is determined by the lender based on the balance. Credit cards are revolving loans. Installment loans are frequently used to purchase big-ticket items like a house or a car, and the lender expects the same monthly payment to be made over a fixed period of time. Mortgages and auto loans are installment loans. Open accounts are charge accounts that must be paid in full each month. American Express is a common charge card. Mortgages are the highest-quality credit type, followed by auto loans. Revolving credit cards are not considered "quality," but build the basis for a solid credit history.
Revolving Credit-to-Debt Ratios: How They're Calculated
It's very simple to calculate your revolving credit-to-debt ratio. Simply add the total of your revolving (credit card) debts and divide that sum by the total of your revolving credit card limits. For example, imagine you have three credit cards, each with a $5,000 credit limit. Your total revolving credit limit is $15,000. On the first card, you have a $0 balance. The second card has a $2,500 balance, and the third card has a $2,000 balance. Your total outstanding debt is $4,500. To calculate your revolving credit-to-debt ratio, divide $4,500 by $15,000, which is 30 percent. This means you've used 30 percent of your available credit.
"Good" and "Bad" Debt Ratios
Low ratios are good, and bad ratios may prevent you from getting a loan. A good guideline is to always keep your revolving debt ratio under 50 percent. This is why it's a good idea to keep an unused credit line open. For example, imagine that the borrower decides to close the $5,000 account without a balance. Suddenly, the credit-to-debt ratio is calculated by dividing $4,500 by $10,000---and the ratio increases to 45 percent. Having too much revolving credit, however, can also affect your ability to get a loan. Mortgage lenders in particular expect applicants to adhere to strict guidelines regarding revolving credit usage.
Your Credit Score
Your credit-to-debt ratio and the amount of time you've used credit are also key factors that credit bureaus use when determining your score. Typically, 45 percent of your of score is composed of "amounts owed" (30 percent) and "length of credit history" (15 percent). The other three factors are on-time payments (35 percent), new credit (10 percent) and types of credit (10 percent). Of course, your credit score considers all credit accounts, not just revolving credit. However, it's much easier to get in trouble with them, so remember that debt ratio the next time you reach for your wallet.
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