How Does Credit Utilization Ratio Affect Your Credit Score?

In a previous article, we've covered how the debt-to-income ratio (DTI) can affect whether you get approved for a loan or credit. In this article, we will cover on credit utilization affects your credit score.

Your credit utilization ratio (also referred to as the debt-to-credit ratio) is a measure of how much credit you’re using compared with your credit limit. For example, let’s say that you have a $10,000 credit limit on your card and your current balance is $3,000, which makes your credit utilization ratio 30%.

Your debt-to-income ratio (DTI) is a calculation of how much of your monthly income is devoted to debt payments and certain other financial obligations. Lenders want to know you have the ability to pay back a loan.

Related: What Your Credit Score Doesn't Tell You, And How To Repair Your Credit

Payments that should be factored into your DTI include:

• Monthly rent or mortgage payments (including taxes and insurance).
• Minimum monthly credit card payments.
• Monthly auto and student loan payments.
• Monthly child support or alimony payments.
• Monthly payments on any other type of loan.

Once you’ve added up all these obligations, divide the total by your monthly gross (pre-tax) income to arrive at your DTI. For example, if your monthly debt payments and financial obligations add up to $2,500 and your monthly income is $6,000, your debt-to-income ratio is 41.7%. In general, a DTI that's lower than 49% makes you eligible for loans.

How Credit Utilization Affects Your Credit

Loans can be either secured loans or unsecured loans. Mortgages and car loans are secured loans, as they are both secured by collateral. Loans such as credit cards and lines of credit are unsecured, not backed by collateral. Unsecured loans typically have higher interest rates than secured loans as they are riskier for the lender. With a secured loan, the lender can repossess the collateral in the case of default.

Loans can also be described as revolving loans or term loans. A revolving loan is a loan that can be spent, repaid, and spent again, while a term loan is a loan paid off in equal monthly installments over a set period called a term.

Let's see how different loan obligations are categorized:

• A line of credit is an unsecured revolving loan.
• A credit card is an unsecured revolving loan.
• A home mortgage is a secured term loan.
• A personal loan is generally an unsecured term loan.
• A car loan is a secured term loan.
• A student loan is generally an unsecured term loan.

Related: Learn how bankers qualify applicants for different types of loans

Your Credit Utilization Ratio is influenced almost entirely by your revolving loans (credit card debt and line of credit). In general, it's best to keep your credit utilization ratio below 30% on any single credit card and across all of them. This also applies to any line of credit extended to you by your bank.

A whopping 30% of your FICO score, the scoring model used in most lending decisions, is determined by your credit utilization ratio. The lower the credit utilization ratio, the better is your credit score.

Why Lenders Use Debt-to-Income Ratio (DTI) To Qualify You For a Loan

Although your debt-to-income ratio isn't used to calculate your credit score, you should know that it's a big factor lenders use to decide whether you qualify for a loan or credit because it indicates how able you are to take an additional financial obligation. In other words, lenders want to know how able you are to pay back your debt and financial obligation, including the new loan you're applying for.

Banks and other types of lenders set their own DTI standards, so an acceptable DTI with one lender might be considered too high with another. In general:

• DTI of 35% or less: Green light. You are looking good, and your lender will favor your application. Compared to your income, your debt is at a manageable level. You most likely have money left over for saving or spending after you’ve paid your obligations.
• DTI between 36 - 49: Yellow light. You are still eligible for a loan, but you have an opportunity to improve your situation. You’re managing your debt adequately, but you may want to consider lowering your DTI. This could put you in a better position to handle unforeseen expenses. Your lender may ask you for additional eligibility criteria.
• DTI of 50% or more: Red light. You need to take action to get your finances in order. In the eyes of your lenders, you may have limited funds to save or spend. With more than half your income going toward debt payments, you may not have much money left to save, spend, or handle unforeseen expenses. With this DTI ratio, lenders may limit your borrowing options or even categorize you as not eligible for loans.

Related: Personal Finance Quickstart Guide for Paying Off Debt, Credit Repair, and Money Management