Credit scores reserve 30% of the weight in their formulas to account for your debt balances. Put simply, the more you owe, the more likely you may default.
This is measured with an emphasis on your credit utilization rate. This ratio determines what percentage of your total credit limits you are actually using.
The higher that your credit utilization rate is, the more points that you lose on your credit scores. Understand that this effect is measured both individually and collectively.
That means that your scores will drop as your total credit utilization rate increases from one month to the next. Your scores will also drop if your credit utilization rate on a single account increases.
Consider this example:
| Card 1 | Card 2 | Card 3 | Totals | |
|---|---|---|---|---|
| Credit Limit | $2,000 | $5,000 | $10,000 | $17,000 |
| Balance | $800 | $4,800 | $2,600 | $8,200 |
| Utilization Rate | 40% | 96% | 26% | 48.2% |
This debtor has an overall credit utilization rate of 48.2%. Any time this figure exceeds 30%, the impact on credit scores is more noticeable. According to Craig Watts, spokesperson for Fair Isaac Corporation (developer of FICO scoring models), anytime your credit utilization rate exceeds as little as 10% there is some detrimental impact to your credit scores.
For this debtor, they are being penalized for having a utilization rate of 48.2%. While it could be much higher, it could also be much lower. This debtor is also being penalized on the individual accounts. They may be losing the most points on their credit scores due to their 96% utilization rate on Card 2. This account is very near the credit limit and the debtor is in imminent danger of going over-the-limit. Credit scoring formulas factor increased risk of default anytime an account nears the credit limit, since debtors who max out their accounts tend to incur over-the-limit fees that can further impede their ability to pay off the debt.
Many debtors make the mistake of closing accounts while they still have high balances on other cards. What this does is increase their overall credit utilization rate. This effect is magnified if they transferred the debt to another card rather than paying it off.
For credit scoring purposes, the debtor in our example should concentrate on paying off Card 2 first, since that is the account that is causing the most damage. In the real world, our debtor would also need to consider which account has the highest interest rate. While paying off the card with the highest credit utilization rate may improve credit more in the short term, paying off the card with the highest interest rate will save the most money and ultimately help you pay off all of your debt faster. That in turn will lower your overall credit utilization rate faster.
There is an additional factor that most experts fail to mention that can also reduce your credit scores. Having debt balances on too many accounts can also lower your scores. There is nothing wrong with having many open accounts. What you do want to avoid is running up balances on many accounts. Fair Isaac is aware that the more accounts that you carry balances on, the more opportunities you have to forget to make an on-time payment. That by itself can also lower your scores!
If you can afford to make extra payments to your cards and are not using them much, paying them off will help you increase your scores. Closing paid off accounts that you do not want to keep may be done at any time, but it could lower your scores if you close accounts before you pay off all of your balances. If you can barely afford your payments as is, then you are showing signs of financial distress that may require intervention by a credit counselor.
Credit cards are not the only accounts that consider this credit utilization rate. Installment loans can also affect your scores similarly, although you are not necessarily penalized the same way for being maxed out since all installment loans begin this way. Understand though that an installment loan will provide the most benefit to your credit scores once you have paid off a considerable amount of the original balance. The value of any collateral is completely ignored here.
Long is a graduate of the University of North Carolina at Chapel Hill with a B.A. in Industrial Relations. He subsequently received his Certificate in Nonprofit Management from Duke University. His Certificate in Financial Planning was issued by Florida State University.
Long has achieved the Accredited Credit Counselor and Accredited Financial Counselor certifications through the Association for Financial Counseling, Planning and Education. Long originally achieved the Certified Credit Counselor designation through the National Institute for Financial Education.
In addition to years of nonprofit leadership, Long has been an innovator in the field of volunteer tax return preparation programs. He assists volunteer associations and nonprofit organizations who seek to integrate credit counseling and asset-building programs with free personal income tax preparation. His approach to using free credit reports as both an incentive and a screening tool for placement into asset-building programs has been shared with members of the National Community Tax Coalition, the EITC-Carolinas Initiative of MDC, Inc. and nonprofit groups across the Carolinas.
Long assists members of our armed forces in the Carolinas, Iowa, Rhode Island, Georgia and Germany with financial readiness. Please support our Soldiers, Marines, Airmen and Sailors!
Favorite quote:
"The democracy will cease to exist when you take away from those who are willing to work and give to those who would not."
Thomas Jefferson
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