One of the factors lenders consider when determining whether to issue a loan is your debt-to-credit (DTC) ratio. This figure is representative of your outstanding amount of debt as compared to the amount of debt that is currently available. The lower your debt-to-credit ratio, the better you look to a prospective lender.
How Debt-to-Credit Ratios Work
Let’s say you have a total credit limit of $20,000 and you have $5,000 in credit card debt. This would give you a debt-to-credit ratio of 25%. (5,000 = 25% of 20,000). Now, let’s say a friend of yours has a credit limit of $40,000 and $20,000 in credit card debt. This leaves them with a 50% ratio (20,000 = 50% of 40,000).
So, even though they have more credit available to them than you do ($20,000 vs $15,000), your debt-to-credit ratio is lower. All other things being equal, lenders would likely consider you as a better risk than your friend.
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Debt-to-Credit vs Debt-to-Income
Debt-to-income (DTI) is the percentage of your income owed to debt service each month. Let’s say you and a friend both earn $10,000 each month before taxes and deductions (your gross monthly incomes). Your friend’s debt payments total $5,000 each month (50% of their income) and yours total $2,500 (25% of your income).
In this scenario, your debt-to-income ratio is better than your friend’s. It takes half of their earnings to service their debt, but you need only a quarter of yours for the same purpose.
Another key difference between DTC and DTI is that debt-to-credit only considers your revolving accounts, such as credit cards and lines of credit. Meanwhile, debt-to-income looks at all of your monthly recurring debts including mortgage payments, rent, car payments, and the like.
Why They Matter
While your DTC plays a role in establishing your credit score, your DTI does not. However, your DTI does come into play when lenders are considering you for a loan.
Creditors prefer being one of a few lenders you owe, rather than being one of many. The idea here is the fewer outstanding debts you have, the more likely you are to meet the terms of the loan agreement you sign. Thus, a low DTC signals you tend to use credit responsibly and are likely to be a better risk.
While your DTI can also indicate risk, it’s looked upon as a more accurate indicator of your ability to pay, as opposed to your willingness to pay. After all, the less of your income you need to support your lifestyle, the more you’ll theoretically have to repay a loan.
What are Good Debt Ratios?
Lenders prefer to see a debt-to-credit ratio of 30% or less. Anything above that figure will decrease your credit score, which in turn will mean higher interest rates. The worst case scenario is a refusal of credit in some instances.
Where the debt-to-income ratio most often comes into play is when a lender is considering a mortgage application. In such cases, they prefer to see a debt-to-income ratio of 43% or less. In fact, anything over 43% can trigger a loan denial.
Stick With The Facts
Your debt-to-credit ratio reflects the total amount of debt you have each month as compared to your gross monthly income. By having a solid understanding of both of these metrics, you’ll know how they can affect your ability to qualify for credit and the interest rates you can expect to pay.