Money Talks, So Should You

Q&A: What’s the ideal credit limit to debt ratio?

Mechel Glass
by Mechel Glass, Dimespring Contributor  (@CredAbility)

The answer to this question will change somewhat depending on an individual’s financial situation and goals, but I can offer a few rules of thumb.

First, let’s define the kind of debt we’re talking about. I’ll focus on credit cards, the balance you owe compared to how much you could borrow if you charged them up to the limit. That means we’ll exclude from this discussion other debts, including mortgages, student loans and medical debt or loans from retirement plans.

Now, some people might argue that the ideal credit card debt ratio is zero. That’s fine for people who don’t plan to use credit, or borrow money to buy a home, car or boat.

READ: Q&A: What is a debt-to-income ratio?

But for the rest of us, the responsible use of credit cards is a good way to create a credit profile that will earn us low interest rates when we’re shopping for a car or home.

So, with those qualifiers in mind, here is my answer: the ideal credit to debt limit is about 5 percent.

Carrying a balance at this level is a fairly low risk way to build a credit history that shows you can manage your credit card accounts responsibly. It also helps ensure that you are showing activity on your cards, which will decrease the possibility that your limit will be lowered.

READ: Q&A: How do I determine which debts I should pay off first?

Carrying a small balance is especially helpful for younger people just starting to establish credit. Creating a history of borrowing followed by timely payments gives potential future creditors a positive record to help determine if they should lend you money.

I’m well aware that not everyone handles credit cards as strategically as I’ve just outlined. If carrying a 5 percent balance is an ideal ratio to improve your credit score, sirens should go off in your head if your ratio creeps over 30 percent.

At over 30 percent your credit score is at risk and at 50 percent your score will almost certainly start moving in the wrong direction.

The way you manage your debt-to-credit-limit ratio determines how you rate in one of the three big Cs of credit.

READ: Q&A: How can I get my debt under control?

One is for “capacity,” or your ability to pay back the debt, typically with a steady income. A second is “capital,” or your assets that might cover the debt if you lose your income stream.

And the third is “character,” which is your history of handling credit responsibly. If you consistently manage a debt to credit ratio at or below 5 percent, you should make steady improvement to your “character” profile that will be considered by potential future lenders.

 

Mechel Glass is vice president of community outreach for CredAbility. She is responsible for coordinating community outreach and financial education activities across the agency’s regions and developing new education programs for both classroom settings and online. Glass, a U.S. Army veteran, is also co-author of “The Veteran’s Money Book,” scheduled for publication in April 2014 by Career Press. The book can now be ordered on Amazon.com.