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Debt to Credit Ratio

How do I increase my amount of available credit and lower my debt-to-credit ratio? Is debt consolidation the answer?

I would like an expert opinion on a debt consolidation loan. I have excellent credit and pay my bills very timely but have a high debt to credit ratio. What are some good options to increase the amount of my available credit?

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Highlights

  • Debt-to-credit ratio is also known as credit utilization ratio.
  • Determining what a good or bad debt-to-credit ratio is difficult.
  • Review two sure-fire ways of altering your debt-to-credit ratio.

When you mentioned your debt-to-credit ratio, what you are referring to is also known as the credit utilization ratio. Simply put, it is the amount you owe in relation to your total available credit converted to a percentage. For instance if you have five credit cards total and each one has a credit limit of $10,000, your total available credit on all cards is $50,000. Now let us say you owe a total of $40,000 on all of them together your credit utilization is 80%. Generally the further you get above 60% debt-to-credit ratio the more points you lose off your score.

Many experts believe a 40-60% credit utilization is best. However, experience tells me if you are at 100% a credit score suffers. If you pay down your amounts owed to bring your credit utilization factor down to 50% it will probably raise your credit score. I hasten to add that there is disagreement about these numbers and rules of thumb. That is because these informal rules are based on observations of FICO scores, which are generated by algorithms created by Fair, Isaac & Co. These algorithms are proprietary and are under constant revision, which makes it difficult to state when a good debt to credit ratio crosses the line and becomes bad.

I would suggest you spread your debt over a few of your trade lines so that no single account you have has a credit utilization ratio of over 30%. This should help your credit score if that is your goal.

You mentioned increasing your amount of available credit. There are two ways to alter your debt-to-credit ratio. You mentioned the first, which is to increase your amount of available credit.

Increasing Available Credit

To be simplistic, an easy way to increase your amount of available credit is to apply for and get a larger available credit balance from your creditors. In the case of a credit card, if your available credit balance is $500, you could ask for it to be doubled. Three years ago, it is likely your credit card issuer would have approved your request as a matter of course if you had a consistent and timely payment history. In 2010, however, the adults are back in charge at credit card issuers, and they will want to know your debt to income ratio.

Debt-to-Income ratio (DTI) is a comparison of your monthly gross income and your monthly repayment obligations to creditors. For example, if you bring home $4,000 each month and your debt payments total $1,000, your DTI would be 25%. When you apply for new credit or seek to boost the credit limit on an existing account, potential lenders look at your DTI to determine if you can afford your current debt payments, and if so, how much additional debt you can afford to repay. DTI is one of the most important factors considered by potential lenders, as it is a good indication of your ability to repay the loan.

Every lender determines its own guidelines regarding allowable DTI ratios for loans. Generally speaking, a DTI above 55% is considered very risky, and could make obtaining a new loan difficult. Also, you will usually want to keep your debt-to-income ratio below about 29%, as a rule of thumb.

The key question you need to ask, and the number you did not include in your question, is what is your DTI? If you have a low DTI today, then it may be possible to increase your available credit by applying for more credit. However, if your DTI is 30% or above, then you may need to consider your second option. Your second option is cutting your amount of debt to lower your debt-to-credit ratio.

Decreasing Your Debt

The four primary concerns for most consumers carrying significant debt loads are: i) size of monthly payment and ability to make it ii) time to debt freedom, iii) total cost to pay off the entire debt, and iv) the credit rating impact of the resolution program. Be sure to evaluate each program relative to your prioritization of these factors.

Since there are a variety of debt resolution options, including credit counseling, debt negotiation/debt settlement, a debt consolidation loan, bankruptcy, and other debt resolution options, it is important to fully understand each option and then pick the solution that is right for you.

You mentioned a debt consolidation loan.

Debt Consolidation Loan

Many people think first of a debt consolidation loan when seeking debt consolidation. It is really the only true consolidation, where the original debts are paid off by a lender who assumes the new debt. The most common forms of debt consolidation loans are home loan refinancing, taking out a second loan on a home (or a home equity line of credit) or, obtaining an unsecured loan. Since the credit crunch occurred, obtaining an unsecured loan at a reasonable interest rate has become quite difficult or impossible. In a debt consolidation loan, you exchange one loan for another. The most frequent form is taking out a mortgage loan, which carries a lower interest rate and is tax deductible, to pay off high interest rate credit card debt.

It is important to be aware that shifting unsecured debt to secured debt can create a volatile situation. If there is ever a chance that you cannot afford the new mortgage payment, you put yourself at risk of foreclosure! In the case of a debt consolidation loan, most mortgages are 30-year loan, which means that the total cost and the time to debt freedom could be very high, but the monthly payment will be lower than other options and there is no credit rating impact.

Credit Counseling

A Consumer Credit Counseling Service (CCCS), is one specific type of debt management plan. It is a very common form of debt consolidation. There are many companies offering credit counseling programs. In a CCCS program, you make one payment to the CCCS firm and they then distribute that payment to your various creditors. CCCS firms negotiate lower interest rates with your creditors. By obtaining interest rate concessions from your lenders or creditors, more of the payment you make each month goes to the principle balance, thereby speeding up the time it takes to become debt free. Because the program lowers interest rates, it less effective for someone whose interest rates are already low.

It is important to understand that in a credit counseling program, you are still repaying 100% of your debts, plus some interest. Often, in Consumer Credit Counseling program, the size of the payment is not significantly lower than your current monthly minimum payments you are sending to your creditors. This means that if you are having trouble making your current payment, a CCCS program may not be right for you. The program demands that you make a timely payment each month. If not, you could end dropping out of the program without having resolved the debt problem. Although there are no precise figures available, a high percentage of people who enroll in a CCCS program drop out. On average, most credit counseling programs take around five years. While most credit counseling programs do not impact your FICO score, being enrolled in a credit counseling debt management plan does show up on your credit report and affects your credit rating. Unfortunately, many lenders look at enrollment in CCCS program as akin to filing for Chapter 13 Bankruptcy; in both cases you needed the assistance of an outside firm to re-organize your debts.

Debt Settlement

Debt settlement, also called debt negotiation, is a form of debt consolidation that reduces your total debt. Savings can be as much as 50% and debt settlement programs will significantly reduce your monthly payments. Debt settlement programs are geared for people who have a financial hardship that makes it so they either cannot pay their bills or are about to start falling behind. Debt Settlement programs typically run around three years. It is important to keep in mind, however, that during the life of your debt settlement program, you are not paying your creditors. This means that a debt settlement solution of debt consolidation will negatively impact your credit rating. Your credit rating will not be good, at a minimum, for the term of your debt settlement program. However, debt settlement is usually the fastest and cheapest way to debt freedom, with a low monthly payment, while avoiding Chapter 7 Bankruptcy. The trade-off here is a negative credit rating versus saving money.

Bankruptcy

Bankruptcy may also solve your debt problems. A Chapter 7 bankruptcy is a traditional liquidation of assets and liabilities, and is usually considered a last resort. Bankruptcy is a public matter. You need to stand in public and declare that you are unable to pay your debts. Notices are published and your credit report will show that you filed for bankruptcy for at least 7 years. Since the most recent federal bankruptcy reform went into effect, a few years ago, it is much harder to qualify for Chapter 7 bankruptcy. It may be the case that a Chapter 13 bankruptcy will be the only one available. In a Chapter 13 bankruptcy, a person's debts are reorganized. The debts are repaid, according to the terms established by the bankruptcy court. Chapter 13 bankruptcies usually run three to five years. If you are considering bankruptcy, I encourage you to consult with a qualified bankruptcy attorney in your area.

Default

You may be curious what may happen if you do nothing. If you stop paying your unsecured debts, creditors have the right to collect the debt. First, you will likely receive collection calls and letters from the creditor directly. If you are still unable to pay the debt after several months, the creditor is likely to refer the account to a third-party collection agency.

Third-party collectors are known to be much more aggressive in their collection tactics than original creditors, so do not be surprised if the calls become more persistent, or even threatening. Thankfully, the Fair Debt Collections Practices Act established rules that govern the behavior of collection agents. However, unscrupulous debt collection agents do not follow these rules. If you know your rights, you can protect yourself from improper creditor contact.

In some cases, when all other collection efforts fail, a creditor will decide to file a lawsuit against the debtor. This is not a frequent occurrence, but it is within a creditor's rights and a possibility about which you should be aware. If one of your creditors sues you, the court will likely issue a judgment in the creditorÂ’s favor. Depending on your state's laws regarding the enforcement of judgments, the creditor may be able to garnish your wages, levy your bank accounts, place a lien on your property, or take other action to enforce its judgment.

Regarding a credit report, defaulting on a debt damages a credit score severely. In addition, default is a warning flag for many lenders, who will refuse to deal with a potential customer with a default on their record. As a result doing nothing and allowing default is a poor option for most consumers.

Summary

Although there are many forms of debt consolidation, many people with good to perfect credit who own homes should look into debt consolidation loans, while consumers with high credit card debt and poor credit may want to explore debt settlement or debt negotiation. However, each consumer is different, so find the debt consolidation option that fits for you.

Lastly, here are some fast tips for your own quick Debt Consolidation Evaluator:

1. If you have perfect credit and have equity in your home -- consider a Mortgage Refinance.

2. If you can afford a healthy monthly payment (about 3 percent of your total debt each month), your interest rates are a problem, and you want to protect yourself from collection and from going delinquent -- consider Credit Counseling.

3. If you want the lowest monthly payment and want to get debt free for a low cost and short amount of time, AND you are willing to deal with adverse credit impacts and collections -- then evaluate Debt Settlement.

4. If you cannot afford anything in a monthly payment (less than 1.5 percent of your total debt each month) -- consider Bankruptcy to see if Chapter 7 might be right for you.

Bills.com makes it easy for you to apply for traditional forms of debt relief.

Recommendation

Now that I have provided a general framework, allow me to address your specific situation. As I mentioned, you have two options to alter your debt-to-credit ratio: cut your debt or increase your available credit. You did not mentioned your DTI or present amount of debt, so it is impossible for me to say which option is smarter for you. Based on the discussion above, you should have the tools necessary to make the right choice based on your circumstances.

I hope this information helps you Find. Learn & Save.

Best,

Bill

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