Understanding Credit Utilization and FICO Credit Scores Credit Cards

Understanding Credit Utilization and FICO Credit Scores

21 Dec, 2010 Credit Cards Credit Scores Scores

Credit scores are used in nearly every industry to determine the financial stability of a person or business. There are two main types of credit scores – PLUS and FICO – with the latter being the most commonly used. Credit reports are issued once every three months by the three major credit reporting agencies, although the credit score itself is updated on a monthly basis. Maintaining a good credit score is the key to gaining approval for credit cards, mortgages, vehicle loans, and any other form of financial assistance.

How is the FICO Credit Score Calculated?

The FICO credit score is calculated based on five main factors – payment history (affects 35% of the credit score), amount owed (affects 30%), credit history length (affects 15%), new credit (affects 10%), and types of credit used (affects 10%). Each of these factors is split into a plethora of subsections that contribute to the overall score. A major part of the amounts owed factor that is incredibly influential towards the credit score is credit utilization, which affects 20% of the credit score. The following information explains credit utilization and its effect on the credit score.

What is Credit Utilization?

Credit utilization, also known as the debt-to-credit ratio, is calculated by dividing the total sum of all credit account balances by the total sum of all these accounts’ credit limits. For example, a person with three credit cards that each have a $500 credit line (a total credit limit of $1500), and a total of $375 in outstanding debt (across all three cards) would have a debt-to-credit ratio, or credit utilization rate of 25% (as $375 is 25% of $1500). Contrary to popular belief, it does not matter if one card is maxed out, as long as there is a significant amount of credit left on other credit cards. Experts recommend keeping the debt-to-credit ratio below 30%, as anything higher could cause lenders to believe the cardholder is a risk.

Credit Utilization Tips

Any time a credit card account is closed, the total amount of credit available becomes less, causing the debt-to-credit ratio to rise suddenly. Thus, many experts recommend against closing credit accounts without first paying down the total amount of debt, in order to mitigate the effect of eliminating an entire credit line. Paying more than the minimum due, making every effort to keep balances from rolling over past the grace period, and spending frugally with credit cards is the best way to manage the credit utilization rate and build a good credit score.

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