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The Secret Ratio That Could Damage Your Credit Score

business headacheDo you know your credit score? If you don’t, you’d best learn it. Whether or not you can get credit, how much credit you can get, how much interest you’ll pay on your debts and what you’ll pay for your auto insurance will all be based on your credit score.

Where to get your score

FICO is the company that invented credit scoring. You could go to its website, www.myfico.com, and get your score free if you’re willing to sign up for a free trial of its Score Watch program. If not, you could get your score for $19.95.

A good credit score

Credit scores range from 300 to 850. Any score above 700 is considered to be a good score. Conversely, a score below 500 is considered to be a bad or poor credit score.

What affects your credit score

No one knows exactly how FICO calculates credit scores as this is a deep, dark, proprietary secret. However it is known that there are five components to your credit score. The first of these is credit usage or how well – or poorly – you’ve handled credit. The second is “credit utilization” and is said to make up 30% of your score. It is based on your debt to credit ratio or the ratio of your current revolving debt to the total amount of revolving debt you have available or your credit limit.

An example

Let’s suppose you have three credit cards that have a total credit limit of $15,000. Also for the purpose of this example, let’s suppose you owe a combined $8000 on the three. Dividing $8000 by $15,000 yields a debt to credit ratio of 53%.

What’s good, what’s bad?

Most financial experts say that a good debt to credit ratio is 10% to 20%. If you have a debt to credit ratio of 53% like the example given above, this would be bad and would have a negative impact on your credit score.

What to do if you have a high ratio

Of the five components that make up your credit score, credit utilization is the easiest to change short-term. All you need to do is pay down your debts so that you’re “utilizing” less of your available credit. Conversely, you might get more credit, so that once again you are utilizing less of what you have available.

A good article

There was a good article about understanding credit utilization on the Chicago Tribune website recently. One of the points it made was that the downside of opening new credit card accounts (to boost your limit) means a credit check and a small reduction in your credit score.

A better solution

A better solution than opening new accounts to increase the amount of credit you have available is to request a raise from one of your current credit card companies. If you can talk one of them into raising your limit, this doesn’t set off an alarm at the credit agency the way a request for new credit does.
What not to do

If you’re working to reduce your debt it’s not a good idea to close credit cards when you pay off their balances. This will decrease the amount of total amount of credit you have available, which will affect your debt to credit ratio. For example, if you have two credit cards that have a total credit limit of $1000 and close one of them, your amount of available credit immediately drops to $500.

The ones with the longest history

If you do decide to close some of your credit cards, keep the ones with the longest credit history, assuming they don’t come with annual fees. You might put the cards in a drawer and just use them occasionally to keep them active. That way the credit card companies won’t cancel your cards for lack of use.