Having a poor credit score can affect your life as a consumer. For instance, if you’re shopping for a type of installment loan, such as a car loan or mortgage, you may not get the most favorable rates, terms and amounts. The higher your credit score, the less you’re seen as a risk to lenders. In turn, you’ll be able to secure more favorable terms on loans.
You may have been well aware that not paying your bills on time, being late on payments and not having a healthy mix of credit may negatively impact your credit score, but so can having too much debt.
“Having a lot of credit card debt could make it difficult to get approved for loans and credit lines, or lead to higher interest rates if you are approved,” says freelance credit writer Louis DeNicola. “The debt can impact your credit score and your debt-to-income ratio, two important factors in many lending decisions.”
We’ll go over how much debt is too much and how you can get help with digging yourself out of a debt grave.
Debt-to-Income Ratio Versus Credit Utilization Ratio
A debt-to-income ratio, or DTI, is how much of your monthly income goes toward debt in relation to your total income. This debt can include credit card debt, debt from your monthly rent or mortgage, auto or student loan payments, or another type of loan. It can also include your monthly child support or alimony payments.
This ratio is expressed as a percentage. For instance, if your take-home pay before taxes is $5,000 and $2,000 of that goes toward debt, your debt-to-income ratio is 40%.
A debt-to-income ratio is commonly confused with a credit utilization ratio, which is how much credit you’re using relative to the total amount of credit available. Your credit utilization ratio makes up 30% of your credit score. For instance, let’s say you have three credit cards, and the total maximum credit on all three cards is $20,000. And you carry a balance of $5,000. Your credit utilization ratio is 25%.
Note that while your credit utilization ratio does impact your credit score, your debt-to-income ratio does not.
How Much Debt Is Too Much Debt?
Having too much debt can ding your credit. “When it comes to credit card debt, the lower your utilization ratio, the better, and it can help show lenders that you’re not overextended,” says DeNicola. The remaining balance on installment loans, how many accounts you have with a balance and the amounts you owe on specific types of accounts can also impact your score, explains DeNicola.
So how much credit card debt is too much? As a general rule, you want to keep it below 30%. But if you’re trying to boost your score in a hurry – for instance, you’re preparing to apply for a mortgage – then keep it below 10%, explains Beverly Harzog, credit card expert and author of “The Debt Escape Plan.”
If your credit utilization ratio is over 30%, you’ll appear as being in need of funds and thus seen as a greater risk to creditors.
What Happens When You Have Too Much Credit Card Debt?
If you have too much credit card debt, your credit utilization ratio will go up, which can be a red flag for your card issuer, explains Harzog. This situation could make you seem risky to an issuer. In turn, it could result in an interest rate increase or a lowered credit limit, or it could make it more difficult for you to obtain new forms of credit.
What Is an Unhealthy Debt-to-Income Ratio?
Your DTI typically comes up when applying for a mortgage. “Lenders want to know that the loan you want will not overextend you financially, and that you have enough money to pay your bills,” says credit expert Kimberly Rotter.
When you have a DTI higher than 36%, that suggests you have too much debt, points out Harzog. And regardless of your credit score, you might not be able to get approved for some types of loans or credit if your DTI is too high, points out DeNicola. The specific ratio can vary depending on the financial product and lender, but sometimes there are guidelines. For example, to get qualified for a mortgage, your DTI may need to be 43% or lower.
When it comes to home loans, your DTI is expressed in two ways, explains Rotter:
- The front-end DTI: This is your total housing expenses divided by your total monthly income before taxes. “Housing expenses” includes the principal and interest payment on your loan, mortgage insurance, homeowners insurance, property taxes and HOA fees if required.
- The back-end DTI: This is your total debt payment divided by your monthly income before taxes. Your total debt includes your housing expenses plus any credit card minimum payments, your auto loan, your student loans and any other monthly payments you’re obligated to make.
How to Get Help
There are free credit monitoring services that not only give you your credit score but also give you a “credit report card” that shows the areas where you can improve the most. Plus, you’ll receive tips explaining exactly what you can do to boost your credit score.
If you’re drowning in debt, you can receive free debt relief management from non-profit organizations such as the National Foundation for Credit Counseling (NFCC) or Clearpoint Counseling. Trained counselors may be able to help you create a plan to break free from the cycle of debt, and they may be able to talk to creditors on your behalf. “Getting a handle on your debt is the best gift you can give yourself, and the knowledge will last a lifetime,” says Rotter.
You can also look into debt consolidation, where you consolidate all your debts with a debt consolidation company. You agree to make monthly payments to the debt consolidation company. Not only will this help simplifying things, it can lower your monthly payments, which may give you some breathing room. You may also be able to negotiate a lower interest rate, which could help you save on the total amount you owe on your debts.
As you can see, it’s important that you don’t have too much debt. Otherwise, you may run into challenges getting approved for loans with favorable rates and terms. In turn, it’ll cost you more.
Check out our tips for chipping away at debt so you can have an optimal DTI.
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