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Does the balance-to-limit ratio only apply to credit cards, or does it apply to installment loans, such as student loans or auto loans, as well?
- NDR
Dear NDR,
The balance-to-limit ratio only applies to revolving accounts, like credit cards. With a credit card, you have a set credit limit, but you control the balance by making charges or payments.
Your balance-to-limit ratio, also called your utilization rate or utilization ratio, is calculated by dividing the total of all your credit card balances by the total of all your credit card limits.
High utilization can be an indicator of credit risk, so the lower your balance-to-limit ratio, the better.
Balance-to-Limit Ratio Versus Debt-to-Income Ratio
The concept of a balance-to-limit ratio doesn't apply to installment loans, such as student loans or auto loans. Installment loans are made for a specific amount that you repay with set monthly payments. You have no choice in how the account is managed.
As the balances on installment loans get smaller, it can help credit scores because you are reducing your overall debt. Less overall debt generally indicates lower risk of default.
However, there is another important ratio that installment loans do factor into. That ratio is called your debt-to-income ratio. It is particularly important in mortgage lending, but can also play a part in other credit transactions, such as buying a car.
This ratio compares your total monthly payments on all of your debts to your total monthly income. It gives lenders insight into whether you have sufficient income to make the payments on additional debt.
To calculate your debt-to-income ratio, add up the monthly payments for all of your debts including installment loans and credit cards. Divide that amount by your total monthly income before taxes have been taken out. Ideally, the ratio will be less than 35 percent including your monthly mortgage payment, and 20 percent or less if you exclude your mortgage.
Experian's free Financial Profile shows you what lenders look at in assessing your creditworthiness. It provides a free credit score, calculates your debt-to-income ratio based on information you share and provides other details about your credit use. You will also receive tips to help you prepare for success the next time you apply.
Lenders May Calculate Debt-to-Income Ratio
Income isn't part of your credit report. You provide that information when you complete the application. Because income isn't part of a credit report, credit scores might not consider the debt-to-income ratio. Instead it will be calculated separately by the lender as part of its decision-making process.
Like the balance-to-limit ratio, it is important to keep your debt-to-income ratio low to show that you are not overextended or abusing credit.
While credit scores might not consider the debt-to-income ratio, they do factor in the installment debts and whether your payments are made on time, so you should treat those debts with equal seriousness.
Thanks for asking.
Jennifer White, Consumer Education Specialist