How Debt Affects Your Credit Score

Got credit card debt? You’re not alone.  Americans have 609 million credit cards, according to the Federal Reserve Bank of Boston – with an average of 2.7 credit cards per consumer. Credit card debt causes huge strain to your financial and personal lives.  The average household has $15,788 in credit card debt, according to CreditCards.com, and the interest alone can be devastating.

Debt also takes a toll on your credit score, one of the most important aspects of your finances.  It’s a score that determines what interest rate you’ll get on loans and mortgages.  The score also gauges how responsible you are with money.  The goal is to have the highest credit score possible on a scale from 300-850.

Among the many factors that affect your credit score (click here for info on all of the factors), debt is one of the most powerful determinants of the score – 30% accounts for debt or “Amounts Owed.”  Your credit utilization ratio or debt-to-credit-limit ratio gauges how debt will affect your credit score.  This is a ratio that compares what you owe vs. the total available credit limits you have among all of your credit cards.  The goal is to have the lowest utilization ratio as possible. Here is an example:

Let’s say you owe $1,000 on a credit card with a $3,000 credit limit. Your individual utilization ratio for this specific card is 33.3% (1,000 ÷ 3,000)

If you owe $3,000 on another credit card with a $5,000 credit limit, your individual utilization ratio is 60% (3,000 ÷ 5,000)

In addition to weighing the individual utilization ratio from each card, FICO also takes into account the overall utilization ratio, which in this case is the ratio of the total amount of money you owe across all of your credit cards, which is $4,000 (1,000 + 3,000) divided by the total credit limit across all of your credit cards, which is $8,000 (3,000 + 5,000). So your overall utilization ratio is 50% (4,000 ÷ 8,000).

This is a high utilization ratio and would result in a damaged credit score.  Aim to keep your utilization ratio as low as possible, or below 30%.

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This entry was posted on June 14, 2011 at 9:00 am and is filed under Credit Cards, Debt, Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed.