Debt To Income Ratio and Your Credit Score
Most Americans receive high credit ratings, but a significant minority is unable to escape spiraling debts. Figures show that approximately four out of ten credit bureau customers have low credit scores. People are always on the lookout for ways to improve their credit ratings. Cutting credit card debt and never missing loan repayments helps. A credit repair agency can possibly come to the rescue.
When it comes to improving credit ratings, knowledge of how the credit market works makes a difference. Quite a few ordinary people find credit jargon confusing. Some complex credit concepts may be left for financiers and academics to debate. In other cases, a good grasp of the idea aids personal financial planning. It helps to know both strategies to help and those that are ineffective. The debt-to-income ratio is one of these credit concepts worth knowing. It may not directly affect credit scores, but it does influence lenders’ decisions. It is also easily confused with debt-to-credit ratios that influence credit scores.
What is the Debt–to–Income Ratio?
Debt-to-income measures personal debt in relation to taxable income. For example, someone earning $100,000 per year who owes $20,000 has a debt-to-income ratio of 0.2 (or 20%). Those with high debt-to-income ratios find it harder to repay their debts. A look at this ratio helps lenders decide if this person is a good risk. They want to know if the borrower can easily pay off existing debts plus new debt. If the borrower has a good credit score, the lender might agree to lend despite the higher debt-to-income ratio. Experts suggest the debt-to-income ratio be kept below 36%.
Credit bureaus don’t use debt-to-income ratio in their credit score calculations. They might be happy to know this figure, but they don’t receive data on customers’ earnings – only their debt history. Though they cannot figure the debt-to-income ratio, they take into account the customer’s debt-to-credit ratio. These two ratios share a common relationship to debt and influence on lenders, but they should not be confused.
The debt-to-credit ratio shows the percentage of credit the customer uses. For example, if a customer with a credit line of $5,000 uses $4,500, they have used 95% of this credit line. Similar to the debt-to-income ratio, a high debt-to-credit ratio raises doubt about the person’s ability to stay in good credit.
Credit bureaus extract the debt-to-credit ratio from the customer’s credit history. It accounts for 30% of the credit score value. Credit scores improve for customers with low debt to-credit ratios, and the opposite also holds true. People in good credit have debt-to- credit ratios of below 30%. Some experts recommend keeping the debt-to-credit ratio below 10%.
Keep Debt–to–Income and Debt–to–Credit Ratios Low
Although only the debt-to-credit ratio directly affects credit scores, both ratios should be kept low. Debt control will help achieve low ratios in both areas. Ideally, debts should stay below a third of income and available credit. Success in debt reduction raises credit scores and opens new, more attractive financing possibilities.