A credit-to-debt ratio and credit utilization ratio are important figures to understand when examining your financial health. The two ratios, which are opposite calculations of the same thing, often indicate whether you are financially secure, and they can impact your ability to get approved for a mortgage loan, a car loan or some other loan. You can calculate your credit utilization ratio periodically to note how it changes, and you can make changes in your personal lifestyle to improve the ratio if needed.
What is a Credit-to-Debt and Credit Utilization Ratio?
A credit-to-debt ratio is the amount of available credit you have relative to the amount of debt you carry. The credit-to-debt ratio is more often expressed as credit utilization or the credit utilization ratio or the debt-to-credit ratio. However, credit utilization and debt-to-credit ratios compare credit and debt in the opposite way, by measuring the amount of your debt relative to the amount of available credit. Therefore, you typically want a high credit-to-debt ratio or a low debt-to-credit or credit utilization ratio to maximize your credit worthiness. Both indicate you have not used much of your available credit or have paid off most of your balance. People who have low balances on credit cards have high credit-to-debt ratios and low credit utilization ratios. People with maxed out credit cards have low credit-to-debt ratios, but high debt-to-credit or credit utilization ratios. These ratios are different from your debt-to-income ratio, which determines the percentage of debt you owe relative to the money you earn.
How to Calculate Your Ratio
To calculate your credit utilization ratio, divide the total debt you owe by your total available credit. For example, if you have a credit card with a $5,000 limit and currently owe $500 on it, your debt-to-credit or credit utilization ratio is 10 percent (500 divided by 5,000 equals .10, or 10 percent). This credit utilization ratio is the percentage most often used by creditors, lenders and credit reporting agencies when discussing the relationship of your debt to your available credit. A credit-to-debt ratio involving the same factors would be 90 percent, because you still have 90 percent of your credit available. This percentage is used less often in credit discussions. A maxed out card with zero available credit provides a 100 percent credit utilization ratio, because you have used all of your available credit. The lower your credit utilization ratio is, the better off you are financially.
Effects of the Ratio
A high credit utilization ratio has a negative impact on your financial life. It gives you negative marks on your credit score, especially if your balance is high and your payment history is not perfect. These negative marks impact your ability to secure a loan to buy a house or car, or borrow money from banks and lenders in general. However, if you lower your credit utilization (debt-to-credit) ratio, that reflects positively on your credit score, which improves your chances of being approved for a loan.
Ways to Improve Credit Utilization Ratio
A direct way to improve your credit utilization ratio is to pay down your debt without accumulating more. Reducing the amount of debt decreases your credit utilization ratio. Also, you can acquire more credit without increasing your debt to decrease the ratio. Once you pay off a credit card, your credit utilization ratio for that account is 0 percent. However, you may not want to close that account, as closing the account eliminates the history from your credit report, including the positive direction the account went as you paid it off. Perhaps more important, closing a credit card account erases the available credit from the card from your credit report, which, therefore, increases your credit utilization ratio. For example, if you owe $1,000 total on three cards that have a combined available credit of $10,000, your credit utilization ratio is 10 percent. But if you close a card that had a credit limit of $5,000, thus leaving you with $5,000 of available credit, you just increased your credit utilization ratio to 20 percent, even though the amount you owe did not change. Depending on your situation, it may be more advantageous to carry a small amount of debt that you pay off each month than to close an account.
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