What Is the Debt-to-Limit Ratio?
The debt-to-limit ratio is a metric used to assess the creditworthiness of a borrower. It is calculated by dividing the borrower's total outstanding revolving debt (such as on their credit cards) by the total amount of credit available to them. For example, a borrower with $5,000 in credit card debt and a total credit limit of $10,000 on all of their cards combined, would have a debt-to-limit ratio of 50%.
Key Takeaways
- The debt-to-limit ratio compares how much someone owes to how much credit they have available to borrow against.
- It's also referred to by other names, such as credit utilization ratio.
- The ratio is used by lenders to assess the creditworthiness of credit applicants and is also an important component in the calculation of credit scores.
- Borrowers who want to improve their debt-to-limit ratios can do so pay paying down debts more aggressively or taking on additional credit if they qualify for it.
How the Debt-to-Limit Ratio Works
The debt-to-limit ratio has several other names, including balance-to-limit ratio, debt-to-credit ratio, and credit utilization ratio. In all cases, it compares the total amount of revolving debt a person has outstanding at a particular time to the total amount of revolving credit they have available to draw on, expressed as a percentage. It does not consider installment debt, such car loans and mortgages.
Regardless of the name it goes by, the purpose is the same: estimating how close the borrower is to "maxing out" their credit-bearing capacity. In general, a debt-to-limit ratio of 30% or less is considered acceptable by most lenders, while ratios above that level will start to prompt concerns that the borrower may be overextended.
Another common metric, debt-to-income ratio, or DTI, takes different variables into account. Rather than just revolving debt, it also includes installment debts, comparing the person's total monthly debt obligations to their gross income per month. Lenders may take both a prospective borrower's debt-to-limit and debt-to-income ratios into account in deciding whether to grant them a loan or other form of credit. However, unlike their debt-to-limit ratio, a person's debt-to-income ratio doesn't figure into their credit score. That's because the credit reports on which credit scores are based do not include information on the subject's income.
How Debt-to-Limit Ratios Affect Credit Scores
Consumers' credit scores are based on a number of factors, each of which is assigned a weighting according to its importance.
In the most widely used credit scoring model, FICO scores, payment history—basically whether the person has paid their credit bills on time each month—counts for the most, with a weighting of 35%. Next comes what FICO calls "amounts owed," at 30%. A key factor in that category is the individual's debt-to-limit, or credit utilization, ratio. A high ratio can have a negative effect on their credit score, while a lower ratio can have a positive one. However, the company behind FICO scores notes, "In some cases, a low credit utilization ratio will have a more positive impact on your FICO Scores than not using any of your available credit at all."
Important
Credit scores are worth paying attention to for a number of reasons. Not only are they used in lending decisions, they can also come into play in the rates you pay for insurance and even whether a landlord will rent to you or an employer offer you a job. In all of these instances, your credit score is, rightly or wrongly, considered an indicator of how responsible a person you are in general.
Real-World Example of a Debt-to-Limit Ratio
Emma is considering applying for a mortgage. To see where she stands, she obtains both her credit reports and her credit score—which turns out to be lower than she expected. When reading through her credit reports, Emma discovers that her score was negatively affected by her debt-to-limit ratio.
At 50%, Emma’s debt-to-limit ratio is above the 30% threshold that is generally considered acceptable by most lenders. To help improve her credit score, she decides to take active measures to lower that ratio. First, she reworks her budget so that she can pay off a greater portion of her outstanding debt each month. She also applies for credit limit increases on her current credit cards, so that her outstanding debts will shrink relative to her new total credit limits.
Emma might also consider applying for an additional credit card to increase her total credit limit. A balance transfer credit card that charges low or 0% interest for an introductory period could allow her to consolidate her existing debts on that card and pay them off more quickly.
How Can You Improve Your Debt-to-Limit Ratio?
There are basically two ways to improve your debt-to-limit ratio: reducing the amount you owe or increasing the amount of credit you have available to you.
What Is a Good Credit Score?
Credit scores typically range from 300 at the bottom to 850 at the top. Experian, one of the three major credit bureaus, breaks down FICO scores this way:
- 300-579: Poor
- 580-669: Fair
- 670-739: Good
- 740-799: Very Good
- 800-850: Exceptional
FICO's major competitor, VantageScore, also uses a 300 to 850 scale. Experian translates its scores as follows:
- 300-499: Very Poor
- 500-600: Poor
- 601-660: Fair
- 667-780: Good
- 781-850: Excellent
How Can You Obtain Your Credit Score?
You may be able to obtain your credit score free of charge from your bank or credit card issuer. There are also websites that offer free credit scores. Bear in mind that you probably have several credit scores and they may not all match. Both FICO and VantageScores come in multiple versions, and your credit reports, on which your credit scores are based, can differ from one bureau to another.
How Can You Obtain Your Credit Reports?
By law you're entitled to free copies of your credit reports from each of the three major credit bureaus—Equifax, Experian, and TransUnion—at least once a year at the official website for that purpose, AnnualCreditReport.com. Even if you aren't planning to apply for a new loan, it's a good idea to review your reports periodically to make sure they're correct and to spot any accounts you don't recognize, which could be a sign of identity theft. If you find errors, you have a right to challenge them and the credit bureau is required to investigate and get back to you.
The Bottom Line
Your debt-to-limit ratio is an important number in calculating your credit score. If it is not as good as you'd like it to be, there are ways to improve it.
