These are very confusing yet crucial terms to be understood - debt-to-income ratio and debt-to-credit ratio. Before we head on to explain these terms, it is highly advised to have a clear concept on the topics. Then we will differentiate between these two subjects and try to give you suggestions on how to lower the ratios for a better credit score reputation.
Important terms to know first
1. Recurring deposit and billing:
The amount you deposit or pay as bills for a fixed time period to your savings or debts on a regular basis.
The property withheld as safety for future casualty, by the lender, when you apply for loan or credit . Mortgage loan is devised into two parts.
- A: Prime mortgage: Loans delivered to people with credit score above 700 of FICO score
- B: Subprime mortgage: Loans delivered at higher rates of interest to people with a FICO credit score generally below 620.
3. Credit score:
The score generated by consumer reporting agencies worldwide to determine your trustworthiness fore to loan assignment or credit lending.
Credit score is evaluated on five factors. Payment history, total amount owed, length of credit history, types of credit used and new credits.
4. Credit report:
A report delivered by credit bureaus that consists of a person’s total credit history. You can generate credit reports online. They may differ slightly from bureaus to bureaus.
It is the ratio percentage that determines the debt payment to a person’s overall income.
Your debt to income ratio is easy to calculate.
This will give you your debt-to-income (DTI) ratio.
For example: If your monthly income is $1000, and the sum amount of your recurring monthly debt is 500$, then your ratio will be 50%.
The lower the ratio, the better.
Although your debt-to-income ratio barely accounts for your credit score, but you must keep it as low as possible.
This is important for them, as they will add the newly issued debt amount to the existing monthly bill amount and will generate a new ratio percentage.
For example: If your new recurring debt amount is $100 per month, then your new ratio will be ($500 + $100)/$1000. Your percentage will now be 60%, which is really bad.
The best score is always said to be below 28%. Anything exceeding 40% is considered as a risk factor for a lender.
The financial institution may not qualify you for a new loan. The problem may arise while taking out a mortgage or a personal loan.
Tips to lower your debt-to-income ratio:
- The only effective way to lower down the percentage is by lowering your monthly payments and clearing out all debts as much as possible.
- The next is to increase your monthly income so as to decrease the ratio.
It is also known as credit utilization. This is usually applied to revolving credits such as credit cards.
When you open a credit account, you are given a certain credit limit from the company. Credit utilization ratio is the amount of your outstanding balance divided by the credit limit, which is expressed in percentage.
The ideal condition is having no outstanding balance in your credit card account after the payment due date.
The debt-to-credit ratio directly affects your credit score. It nearly covers 30% of your total credit score. The calculation of this percentage is a bit unique.
Account 1: Balance: $300; limit: $1000. Debt-to-credit ratio= 300/1000 i-e 30%.
Account 2: Balance: $400; limit: $1000. Debt-to-credit ratio= 400/1000 i-e 40%.
So your total debt-to-credit ratio will be (300+400)/2000 = 35%.
A good credit utilization ratio can be less than 30%.
The credit utilization ratio is consisted of all your overall debt (that includes your credit cards, loans, mortgages), of which your credit card’s ratio accounts the most.
Credit cards are said to be revolving credits as you are not liable to keep a fixed balance per month. You can always control or avoid payments made with a credit card.
Tips to lower your debt-to-credit ratio:
- Try not to have too many revolving credit accounts. Even if you have, then maintain your purchases or transaction levels as minimum as possible from those accounts.
- A credit card with more credit limit will also help to lower your debt-to-credit ratio.
Whenever you apply for any new credit account, the financial institution will thoroughly check your credit report history. If you can maintain an overall good credit score for a long period of time, you will have lesser problems in opening an account with more credit limit.
Differences between debt-to-income and debt-to-credit ratio:
- There is a big line of difference in the sense that debt-to-income ratio is completely dependent on your gross monthly/annual income, whereas debt-to-credit ratio has nothing to do with your income but with the credit limits set by the monetary organisation on your revolving credit accounts.
- DTI ratio has nothing to do with your credit score, but may have a huge impact during taking out mortgage or other loans. On the other hand, debt-to-credit ratio makes up a huge portion of your credit scores; so, if it’s more than 30%, you may face difficulty to take out loans at suitable terms and conditions.