Debt-to-Limit Ratio

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 debts by the combined credit limits of their loans. For example, a borrower with $5,000 of debt and a credit limit of $10,000 would have a debt-to-limit ratio of 50%.

Key Takeaways

  • The debt-to-limit ratio measures the level of indebtedness of a borrower.
  • It is used by lenders to assess the creditworthiness of credit applicants and is an important component in the calculation of FICO credit scores.
  • Borrowers who wish to improve their debt-to-limit ratios can use strategies such as aggressively paying off their outstanding debts, filing for increased credit limits, or using debt consolidation strategies.

How the Debt-to-Limit Ratio Works

The debt-to-limit ratio has many other names, including the balance-to-limit ratio, the credit utilization ratio, and the debt-to-credit ratio. In all cases, its purpose is the same: estimating how close the borrower is to “maxing out” their credit-bearing capacity. For the most part, a debt-to-limit ratio of 30% or less is considered acceptable by most lenders, while ratios rising above this level will start to prompt concerns.

For consumers, keeping a healthy debt-to-limit ratio is important because it is one of the main factors used to calculate FICO credit scores. These scores are in turn used to inform lending decisions such as whether or not to approve a given customer’s mortgage application. To maximize their chances of being approved, would-be borrowers should take steps to maintain their debt-to-limit ratios at acceptable levels. Examples of such strategies include paying off their outstanding balances regularly or obtaining a higher credit limit on their loans.

The debt-to-limit ratio is the second-most heavily weighted factor used to determine FICO credit scores, accounting for 30% of the overall score. Other components include payment history, the type of debt owed by the customer, how recently new debts were incurred, and how long the existing debts have been owed.

Real-World Example of the Debt-to-Limit Ratio

Emma is considering applying for a mortgage. To prepare for her application, she reviews her existing credit score and is surprised to find that it is lower than she expected. When reading through her credit report, Emma discovers that her score was negatively affected by her debt-to-limit ratio, which measures the size of her total debts as compared to her combined credit limits.

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 her debt-to-limit ratio. Specifically, she starts by reworking her budget so that she can pay off a greater portion of her outstanding debts each month. She then applies for credit limit increases on her existing loans, so that her outstanding debts will shrink relative to her increased credit limits.

Another option that Emma could pursue would be to secure a new loan with a higher credit limit than her existing loans. She could then immediately pay off her existing debts using the proceeds from that new loan. In the end, she would be left with the same amount of debt as before, but with a higher credit limit. This strategy, known as debt consolidation, would therefore reduce her debt-to-limit ratio.