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How Do Credit Utilization Ratio and Debt-to-Income Ratio Affect My Credit Score?
Your credit score is designed to be a snapshot of your financial health. Credit cards and loans offer you a chance to extend your income or make payments over time, but if you fail to use those cards or loans wisely, it will be reflected in your overall credit score.
Your FICO, or credit score, is created using different measures. While every bank uses slightly different ratios or measures, the most common model breaks down five factors to create your score:
- Your payment history is weighted at 35%
- Your credit utilization ratio is weighted at 30%
- The age of your credit is 15%
- The mix of your accounts is 10%
- How many credit inquiries you have is 10%
Credit utilization is a large part of your overall credit score, but you’ll notice that debt-to-income isn’t listed in the credit score model. The affects of debt-to-income are not specifically measured in your credit score, but that ratio does affect other factors within the FICO score calculation.
What Is Credit Utilization?
Let’s say you have a credit card with a $10,000 limit. You spend $6,000 of that $10,000. Now you’ve used 60% of that credit card ($6,000/$10,000 x 100). Your credit utilization rate is 60% on that card. On another credit card you’ve maxed out with a full $10,000 balance. For that card you have a 100% utilization rate. When you combine the two cards to look at your financial health, your overall credit utilization would be 80%.
That is what credit unions are looking at when they measure your credit utilization.
What is Debt-to-Income?
Your debt-to-income ratio, or DTI, is the comparison of how much you earn to how much you’ve spend using credit. This tells lenders (and you) how much cash you have available every month to pay off a new loan or credit card.
Certain factors are included in your overall debt-to-income ratio including:
- Your rent or total mortgage payment with insurance and taxes
- The minimum payments on your credit cards
- Student loan payments
- Car payments
- Child support and alimony payments
- Other fixed loan payments like a personal loan or medical loan
Let’s say you spend $1500 in rent every month, $500 on a car and another $1000 on credit card payments and student loans. Your total debt payments are $3,000 per month. If you make $6,000 per month, your DTI ratio is 50%, or $3,000 divided by $6,000 times 100. If you only bring in $5,000 per month, your DTI increases to 60%.
Banks use your debt-to-income ratio as a basis for loan and credit decisions. Note that the DTI calculation doesn’t consider other things like your utilities, groceries or gas bills that need to be paid every month.
How Credit Utilization Impacts Your Credit Score
We know that your FICO score uses credit utilization as 30% of the total number. That’s almost a third of the total score. We also know that it is best to keep your credit utilization rate below 30% on every card and across all cards.
If you have one credit card, that means keeping your balance below $3,000 on a $10,000 credit limit. If you have multiple cards, you would need to keep all of your balances below 30%. While carrying a zero balance on multiple cards does help to pull the utilization ratio down overall, it doesn’t help you much to have no balance on five cards and two cards completely maxed out at 100%.
The goal of your credit utilization ratio is to see how well you manage your spending and bills every month. Maxing out a credit card, or worse – multiple cards, isn’t healthy. The ideal credit strategy is to charge things for convenience and then pay the balance in full every month. When you let a balance grow on a card, eventually maxing it out, you are telling the credit unions that you can’t pay all or most of the balance and that you’re stretching or even hurting financially.
When credit unions see high balances and a high utilization ratio, they ding your credit score accordingly which can lead to a bad credit score overall, even if you have cash in savings.
It’s important to note that your car loan, student loan, and personal loan aren’t impacting credit utilization. Fixed debt works differently than revolving debt, or credit cards, and credit cards and the only consideration for debt utilization.
When Debt-to-Income Matters
Your debt-to-income ratio isn’t directly reflected in your credit score. That doesn’t mean it doesn’t have an impact, however. Banks consider your debt-to-income ratio when you apply for a loan or credit card. Your debt-to-income ratio is also considered when you apply for a credit increase on a credit card.
If you get a raise and ask for your credit card to increase your credit limit, they might give you a substantial boost based on your new DTI. Then that increased credit score lowers your utilization rate since you now have spent less of your open credit, which raises your credit score.
Likewise, a decent DTI ratio might help you become approved for a personal loan to pay off all of your credit card balances, sending your utilization rate way down and your credit score way up. That loan might also allow you to pay off your debts more quickly, improving your credit score even more.