The Difference Between Debt-to-Income and Balance-to-Limit

The world of credit can be a very confusing place, and we credit-types tend to speak in acronyms. Many of the terms and these acronyms can sound alike, which only adds to the confusion. In my world, the world of credit reporting and credit scoring, using the wrong word, letter, phrase or acronym can turn a seemingly innocent concept into an inaccuracy.

In the world of credit although a pair of terms may sound similar they can describe two very different things that have two very different meanings. One pair of terms that often gets confused or co-mingled is the debt-to-income ratio and the balance-to-limit ratio. Both ratios could certainly have an impact on your ability to qualify for a loan, but only one of these ratios has any impact on your credit reports and credit score.

The Debt-to-Income Ratio

Your debt-to-income ratio, also known as DTI, is a tool lenders use to determine your borrowing capacity. DTI tells a lender how much of your income is already committed to other debts and how much money you have left over after your existing monthly payments have been made. DTI does not demonstrate whether or not you are likely to pay back a new loan according to terms, but rather whether or not you can afford to do so.

To calculate DTI a lender will divide the total of your monthly payments on any outstanding debts by your gross (aka pre-tax) monthly income. The outcome of the equation is always expressed as a percentage. For example, if you owe $5,500 in monthly payments and your income is $10,000/month then your DTI would be 55%. That’s pretty high.

Although DTI is certainly important from a financial viewpoint, it does not have any direct influence over your credit scores. Your income is not listed anywhere on your credit reports so it cannot be considered by credit scoring systems like FICO or VantageScore. Credit scoring models only consider information that is actually on your credit reports.

The Balance-to-Limit Ratio

Your balance-to-limit ratio, also referred to as the revolving utilization ratio or the credit utilization ratio, describes the relationship between your credit card balances and your credit card limits. To calculate your balance-to-limit ratio on an individual credit card account you would divide your balance by your credit limit. For example, if you have a $7,500 balance on a credit card account with a $10,000 limit your balance-to-limit ratio would be 75%. You can also calculate the ratio in aggregate by adding up all of your credit card balances and dividing that figure by the aggregate of all of your credit limits.

Unlike DTI, the balance-to-limit ratio on your credit card accounts can absolutely have an influence on your credit scores. In fact, credit scoring models like FICO and VantageScore not only pay attention to the balance-to-limit ratios on each of your individual credit card accounts but also to your balance-to-limit ratio on all of your credit cards combined.

When your credit card balances begin to climb, your balance-to-limit ratios on those accounts will do the same. An increase in your balance-to-limit ratios generally translate into lower credit scores. Believe it or not even if you make all your monthly payments on time, the fact that you incur large balances on your credit cards will likely lower your credit scores.

How to Lower Both Ratios

When it comes to your DTI and your balance-to-limit ratios the truth is that the lower your percentages, the better. The good news is that you can lower both ratios simultaneously by paying down your credit card balances. Think of it as killing two birds with one stone.

A lower DTI generally leads to more borrowing power while a lower balance-to-limit ratio will typically mean better credit scores. Add to that the fact that paying off credit card balances can save you a ton of money being wasted on interest fees and you have three solid reasons to start paying down your credit card balances today.