When applying for a loan, lenders need to consider how much of a risk it is to lend money. Because of this, lenders care about how much you have already borrowed compared to how much income you have.
This is what they call a ‘debt ratio’. Lenders calculate these by dividing the amount you’ve already borrowed by your income. This calculation excludes mortgages.
The higher your debt ratio the less likely you are to be accepted for a loan.
How do lenders use debt ratios?
Lenders use three ratios:
Annual debt ratio
This is the proportion of total debt owed divided by your annual income. This takes into consideration all debt/credit owed such as credit cards, mobile phones, and loans. This does not include mortgages.
- Alice has £20,000 in loans and has an annual income of £24,000. This equals and annual debt ratio of 83% (£20k / £24k)
- Bob has £10,000 in loans and has an annual income of £30,000. This equals an annual debt ratio of 30% (£10k / £30k)
Monthly debt ratio
This is the portion of your income that is used to pay creditors or debts each month. This is calculated by dividing your monthly debt payments by your monthly income.
- Alice earns £1,500 each month. They spend £500 repaying their debts and other credit agreements each month. This is a monthly debt ratio of 33% (£500 / £1,500)
- Bob also earns £1,500 each month. They only spend £200 repaying debts and other credit agreements each month. This is a monthly debt ratio of 13% (£200 / £1,500)
Revolving debt ratio
This relates to the amount of credit you are using divided by the limits provided by a lender. This applies to ‘revolving credit agreements’ such as credit cards and overdrafts.
- Alice has a credit card balance of £9,000. They have two cards with total limits of £10,000. This is a revolving debt ratio of 90% (£9,000 / £10,000).
- Bob has credit card balances of £1,000. They also have two cards with total limits of £10,000. This is a revolving debt ratio of 10% (£1,000 / £10,000).
If the above ratios are considered too high by the lender, it is likely that you will be declined for a loan. In all the examples above, Bob is much more likely to be approved for a loan than Alice.
How to improve debt ratio
Having high debt ratios can negatively impact your credit score and your future ability to borrow. Whilst income is not a factor in credit scoring, the amount of debt you have and how you are using your debt is. This is reported to Credit Reference Agencies.
Having ‘debt’ can have negative connotations. However, not all debt is ‘bad’ you just have to be smart and consistent with your repayments.
There are ways you can improve your debt ratio:
- Reduce your total debt by paying off credit cards in full each month or overpay more than the minimum repayments
- Avoid applying for new credit cards or loans
- Review your finances to see where you could save money to put toward paying off the debt. If you don’t have a budget, start one. There are many budgeting techniques available such as the 50/30/20 rule
- Consider a debt consolidation loan to make it easier to reduce debt faster. Credit unions offer low interest loans that can be used to consolidate existing debts
- Increase your income which ever way is achievable such as applying for a higher paying job, taking on a second job or selling items online