How Debt to Income Ratio Affects Your Credit

How Debt to Income Ratio Affects Your Credit

While researching your credit score, you may have come across the term “debt-to-income ratio.” On its own, debt-to-income ratio won’t affect your credit score. However, it is a critical part of your overall credit health, and can have a direct impact in a credit application if you apply for a mortgage or major loan.

What is a Debt-to-income Ratio?

Your debt-to-income ratio is the amount of your gross income that goes towards paying debts. Let’s say you make $2500 a month, with $500 of that going towards bill payments and other debts. Your monthly debt-to-income ratio would come in at 20%, which is a little high, but still below the level of 36% that is generally accepted by most lenders. Some government loans will allow for a debt ratio of 40% or even a bit more, but most financial experts agree that 36% is the highest that anyone should have if they wish to remain financially solvent.

We’ve already said that your income has no direct impact on your credit score, but 30% of your credit score is made up your credit utilization rate, which is the amount of available credit that you are using. If your credit card has a maximum of $5000, and you are using $2000 of that, you are using 40% of your available credit. Most experts agree that your credit utilization rate should be lower than 30% to avoid a negative impact on your credit. With this in mind, it is evident that carrying around a balance on your cards is not a great idea, and very well could end up hurting your credit score. It is always prudent to pay off your debts as quickly as possible to keep your credit utilization rate low and your credit score intact.

So then, is there an optimal debt-to-income ratio? Well a ratio of zero would be great, but is pretty much impossible most people to get. The real answer is, the lower the better. This shows lenders that you make enough money to cover your expenses, which paints you as reliable in their eyes. If you need a goal to work towards, a ratio of 36% is a good number to shoot for if you are angling for a home loan and have enough savings on hand for a significant down payment. Otherwise, a debt-to-income ratio of 30% or lower is probably a safer bet. Most banks have a maximum debt-to-income ratio of 40% for consumers hoping to qualify for a mortgage.

Posted in Credit 101
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