Lenders use several factors to determine if they can lend to a person. They are looking at how much risk they take if they lend to someone. The lender's goal is to understand how likely this person will pay back the debt as agreed or how much risk there is of the consumer not making payment. Debt ratios and debt loads are two terms you may hear concerning this.
What Are Debt Ratios?
Debt ratios represent a measure of a person's financial obligations concerning various economic factors such as income, credit limit, etc. For instance, a debt-to-income ratio compares a person's total debt to their overall income. A higher debt-to-income ratio indicates that the individual allocates more income to service debt.
Understanding Debt Load
In personal finance, "debt load" refers to an individual's total debt at any time. That could encompass various forms of debt, such as credit card balances, student loans, car loans, mortgages, personal loans, and other liabilities.
The size of a person's debt load can significantly impact their financial health. A high debt load can make it harder to meet monthly payments, save for the future, or qualify for additional credit when needed. Additionally, carrying a large amount of debt, especially high-interest debt, can lead to increased financial stress and potential credit issues.
Understanding and managing one's debt load is crucial to personal finance. Debt loads should be manageable relative to income, and paying off high-interest debts should be the priority to reduce the overall debt load more quickly.
Types of Debt Ratios
Lenders look at different types of debt ratios to better understand the amount of risk present.
A debt-to-income ratio refers to the amount of debt a person has concerning their income. Lenders determine a "healthy" or safe level of debt ratio here. Still, a debt-to-income ratio of 28% or lower is ideal when using this figure to determine mortgage qualifications.
The debt-to-limit ratio is different. The debt-to-limit ratio, also known as the credit utilization ratio, is a measure used in personal finance that reflects the amount of debt a person has relative to their overall credit limit.
You can calculate this ratio by dividing the total balance of your debt (or the amount you currently owe) by your total credit limit across all your credit accounts. Express the result as a percentage.
For example, if you have a credit card with a limit of $5,000 and you've charged $2,500, your debt-to-limit or credit utilization ratio on that card would be 50%.
Credit utilization is a significant factor in the calculation of credit scores. A lower credit utilization ratio is typically better for your credit score, suggesting you're not over-relying on your available credit. Experts suggest you should keep your credit utilization ratio below 30%.
How Debt Ratios and Debt Loads Are Used to Make Lending Decisions
Understanding debt ratios and debt loads is an essential strategy in determining how much risk is present for the lender. For example, suppose a person has a credit limit of $1,000 but already uses $800. In that case, that's a debt-to-limit ratio of 80%, which is very high. That shows the lender the consumer may struggle to pay back the amount they owe.
The higher these ratios are, the more risk the lender takes. They use this information to determine the following:
- If they should offer a loan.
- How much of a loan will they offer (how much you can borrow)?
- How much interest to charge on the loan?
This information is typically used alongside other data to determine risk. For example, lenders will consider the type of debt. If the loan is secured, which means some asset backs it, there is less risk involved since the lender can seize the asset to repay the borrowed funds if a default occurs.
When debt loads are higher, lenders can also charge more. Because there is more risk, lenders charge more interest on the loan. That means the more debt you have, the more you have to pay for that debt over time. Keeping your debt as low as possible makes it easier and more affordable for you to borrow money.
Managing Your Debt Ratios and Debt Loads
As a consumer, managing your debt load is up to you. Lenders only have access to the amount of debt they lend you, but you control how many loans you apply for and how much they are worth. Understanding where you stand at any given time can require a delicate balance.
For example, having a high amount of available credit is good. That means lenders trust you will repay your debt on time and as agreed. That means you may want that big credit limit. However, suppose you get a big credit limit and charge a high percentage. In that case, that increases your debt load significantly. Over time, you will have a much higher debt-to-limit ratio.
If your debt is very high, it is harder for you to obtain another loan. Ultimately, keeping your debt as low as possible while managing to keep your available credit high can help you to improve your credit history.
How can you do that? Consider these tips for managing your debt load and ratios:
- Stay in the know. Make sure you know how much your limit is on every loan and credit card you have. That way, you know when you are reaching the upper limit.
- Aim for 30% or lower on every loan. If you have a credit card with a $1,000 limit, don't charge more than $300.
- Work to use credit only based on how much you can pay back that month. Keeping your debts low helps you avoid costly interest.
Debt loads are a big part of managing your financial history. If your debt is high now, work to pay it down over time.