Regular readers will surely know what it is. But in case you’re new to the credit world – first let’s do a quick overview of the debt to credit ratio definition:
In a nutshell, it’s the amount of credit you are using.
So let’s say you have a credit card with a $10,000 credit limit. On it you have a $4,000 balance. Your debt to credit would be:
4,000 ÷ 10,000 = 0.40 ratio a.k.a 40 percent utilization of your available credit
Obviously the above example was easy to figure out in your head, but for more complicated numbers you will need a calculator to figure out your debt to credit ratio.Here is the full formula to figure out more complicated scenarios:
Step One: Enter the amount of your balance
Step Two: Press “÷”
Step Three: Enter the amount of your credit limit (or in the case of a loan, the original starting amount)
Step Four: Press “=” and voila, you have just calculated your ratio
By the way, this is also known as your credit utilization ratio.
So that brings us to the question, what is a good debt to credit ratio? Is there such a thing as an optimal ratio or sweet spot that will magically increase your credit score?
The answer is yes and no. Here’s why…
For starters it’s important to point out that the FICO credit score formula is secret. The best anyone [myself included] can do is to make an educated guess based upon all the various clues that FICO has given over the years.
Clue #1 – Averages From “High Achievers”
If you use MyFico.com to check your score they will tell you about a category called “high achievers” which is those who have a FICO score of 760 to 850. They have said this about them:
- On revolving credit accounts (i.e. credit cards) the average debt to credit ratio is 7 percent.
- On installment accounts (i.e. mortgage and other loans) an average of 35% has been paid off (as in 35 percent of the original loan amount)
Understandably, the ratio on mortgages and other loans can be high (35% equity equals 65% utilization). While having installment loans on your credit record is important, the debt to credit calculation on them is largely a null issue. This is why the conversations surrounding this subject are almost always about credit cards.
Clue #2 – The Credit Utilization Brackets
Myself and many others who study credit (such as personal finance writers) frequently say you should not use more than 25 percent or 30 percent of your credit limit on a given credit card.
However, if you want to really get into the weeds a number of clues have been given which suggest the existence of brackets, so to speak, when it comes to credit utilization:
- 10 – 19%
- 20 – 29%
- 30 – 49%
- 50 – 84%
- 85 – 100%
Those numbers were actually posted by a moderator on MyFICO who has 30,000 posts under their belt. While the exact bracket ranges for 10 percent and above may or may not be accurate, there is ample evidence to support that having a debt to credit of 9 percent or lower is best and falling within any bracket above that will adversely affect your score (the higher you go, the more it will hurt).
Clue #3 – FICO “Damage Points”
Back in 2009 FICO pulled the curtain back a bit on their algorithm, by releasing a list of “damage points” which are common mistakes and what their effect on your credit score will be.
While most of FICO’s damage points apply to severe offenses like foreclosure, bankruptcy, and debt settlement, there were some a few clues relating to the debt to credit ratio credit score impact, at least when it comes to maxing out a card:
- 680 credit score with 1 maxed out credit card = 10 to 30 point drop
- 780 credit score with 1 maxed out credit card = 25 to 45 point drop
Source: MyFICO Credit Missteps
Note: Being “maxed out” allegedly includes any ratio that falls within that estimated top bracket of 85 percent to 100 percent.
These damage points don’t tell us much, but they do confirm the fact that having too high of a balance – even if it’s only on one credit card – could negatively impact your credit score. If you currently have a high balance on an account, consider transferring it to another card.
The truth about the true impact
What is debt to credit ratio based on… individual accounts? The cumulative average of all accounts?
The answer is both. The FICO scoring will take into account the credit utilization on an individual as well as a cumulative basis. Unfortunately there’s no way to know exactly how each is weighted. Nor do we know their combined effect.
I have seen many media sources say that credit utilization makes up 30 percent of your credit score… that’s wrong and they’re not reading FICO website very carefully.
What FICO tells us is that the “amounts owed” category makes up 30 percent of your score. However, debt to credit isn’t the only thing in that category. There are other components involved.
So the truth is that credit utilization – when combined with other components – makes up 30 percent of your credit score. Kind of vague, huh? Yeah that’s the point… remember FICO guards their formula like the recipes for Coca-Cola and Colonel Sanders fried chicken.
So what’s the ideal ratio?
With all that said, we’re still left with the question: What debt to credit ratio is ideal?
Chances are, you will get a different question from each source you consult. My personal take? The answer isn’t black and white. I think the degree of impact largely depends on the quality and length of your credit history
For example, years ago before the recession, CreditCardForum veteran jeffysdad played the 0% arbitrage game by borrowing about $54,500 of a $55,000 credit limit on a card and putting that money into a savings account. His score? “I don’t think it’s ever been below 770 and has been as high as 800 or so over the last several years.”
Meanwhile, there are a plethora of posts on the forum from those newer to credit, who see their credit score plummet because of a high debt to credit ratio (even if it’s just on one account).
What’s the lesson here? FICO is like Google. If you think their algorithm is straightforward and easy to decipher, think again! It’s a black box, unfortunately. While there’s no denying a good ratio is low, at the end of the day how your ratio affects your credit score will be influenced by many other factors, too. The one takeaway is that the “beefier” your credit history, the less of an impact higher balances will have.
The easiest way to improve your cumulative ratio?
As mentioned, FICO analyzes the ratio on a cumulative basis (across all cards) as well as on a per account basis.
On a per-account basis, we all know the solution to decreasing the ratio: reduce a card’s balance. Of course that’s easier said than done, since you may not have the cash to do that right now.
But what about on a cumulative basis? One solution: have more credit cards. Even if you don’t use some of them often, just having those extra accounts will increase the cumulative amount of available credit you have. It also gives you the opportunity to spread the spending across multiple cards or transfer balances, thus keeping the utilization on each card below an ideal 30% threshold.
Last updated January 15, 2016