Credit scoring methods rest heavily on the amounts consumers owe. A debt to limit ratio is used to calculate amounts owed and determine lending risk. High debt to limit ratios are dangerous since they may indicate a growing problem with debt management.
What Is a Debt to Limit Ratio and How is it Calculated?
A debt to limit ratio is a percentage of the amount owed on a revolving debt (credit cards or lines of credit) versus the available credit limit. Ratios higher than 10% may negatively impact a credit score.
Individuals can calculate their own debt to limit ratios by assessing the available percentage of credit left on revolving debts. For example, if a person owes $500 on his credit card, yet his credit limit is $5000, he currently carries a debt to limit ratio of 10% since 500 is 10% of 5000.
Credit Scores Are Affected By High or Low Ratios
The purpose of a credit report is to assess an individual’s responsibility with debt and the amount of credit risk he or she presents to a lender. When a large amount is charged on a credit card and is not immediately paid off, this indicates that the individual is not in a secure enough financial situation to successfully pay off the amount.
Lack of financial security, and any red flags that lack of security may present, is taken into consideration by the credit bureaus when credit scores are calculated. A high debt to limit ratio is a red flag that indicates either financial trouble or difficulty in successfully managing debts. Either scenario places a lender at a higher risk when loaning money to the individual. Because of this, the consumer’s credit report will reflect a lower score as a warning to lenders.
How to Keep a Low Debt To Limit Ratio
There are two ways to lower a debt to limit ratio and improve credit scores. One way is to simply pay off as much of the debt as possible. This immediately lowers the ratio of debt owed and improves credit score.
Another common method is to request an increase in credit limit. Although the amount owed remains the same, the ratio changes due to the consumer’s ability to charge more on the card. This also serves to improve credit scores.
Other Adverse Effects of a High DTLR
In addition to a lower credit score, a high DTLR can result in other adverse financial effects such as:
- Higher interest rates on future loans or credit cards
- Increased interest rates on current credit cards
- Higher minimum monthly payments on revolving debts
- The possibility of being turned down for credit or loans