Credit scores can either save you a ton of money or cost you just as much. Ultimately it’s your own credit management habits that will determine whether your credit scores are a financial asset or a liability. For this reason, it’s essential you learn how to earn great credit scores and then follow through on that knowledge. Great credit doesn’t happen by accident. It’s a premeditated effort.
One of the worst assumptions that consumers make when it comes to their credit is the belief that simply paying bills on time is all it takes to safeguard their credit scores. Don’t get me wrong: Paying your bills on time is the single biggest factor in your credit score. However, it’s hardly the only factor — credit scoring is much more complicated than that.
In fact, about two thirds of the points in your FICO and VantageScore credit scores have nothing to do with whether you’re making timely payments. As a result, it’s possible to never make a single late payment and still have a less than desirable credit score.
Of course, credit scoring models do pay attention to whether or not you make your payments on time. That’s a given. However, these same credit scoring models are also designed to focus heavily on what’s called your credit utilization ratio. In fact, your credit utilization is nearly as important to your credit scores as your payment history.
What Is Credit Utilization?
Your credit utilization ratio is the relationship between your credit card limits and your credit card balances. This relationship, expressed as a percentage, is the measurement of how much you owe versus your overall capacity to borrow.
For example, if you’ve charged $1,000 on your credit card, and your available credit limit on that card is $2,000, then your credit utilization ratio is 50% — you’ve used up half of your available credit. And that’s a lot higher than lenders and credit score models like to see.
Why Lenders Care About Your Credit Utilization
The developers of credit scoring models are the people who design and build the mathematical algorithms that calculate your credit scores. These developers focus on your credit utilization for one simple reason: It’s predictive of credit risk. People who utilize higher proportions of their available credit card limits represent a larger risk to lenders.
Keep in mind that credit scoring models are specifically designed to help lenders predict the risk of doing business with you. High credit utilization could indicate that a consumer has experienced a loss or reduction in income. It might also indicate a lack of discipline or an overspending problem.
Regardless of the specific reason behind high credit card balances, one fact is certain: Consumers with high credit utilization rates are statistically more likely to make future late payments or default. This fact makes them less attractive to lenders.
Paying Once a Month Might Not Be Enough
Credit utilization is the amount of available credit you’re using at the specific time your credit scores are calculated. Do you think paying off your credit card balance once each month is enough to protect your credit score from any unnecessary dings in the credit utilization department? If so, you might be in for an unpleasant surprise.
Credit card issuers will only report your balance to the credit bureaus once a month, shortly after the statement closing date on your account. That means thatif you used up a large portion of your credit limit one month – say, racking up $2,000 in holiday purchases on a card with a $3,000 limit — and you paid off the balance in full before the due date but after the statement closing date, the credit bureaus are still going to report your balance as $2,000 and your credit utilization rate as an ugly 67%, even though both are currently, in fact, zero. And that data will remain on your credit reports until a new closing statement is generated the next month.
To avoid this problem, many consumers develop the habit of paying small portions of their credit card balances multiple times per month in an attempt to prevent a high balance from building up. While this isn’t a bad idea, paying off your credit card balances in full prior to the statement closing date is the best strategy. That guarantees you’ll have a credit card utilization percentage of zero, which will be great for your credit scores.
Related Articles
- Credit Utilization: You Can Improve This Part of Your Credit Score Almost Immediately
- Debunking Four Common Credit Myths
- Revolving Credit vs Installment Loans: Why the Type of Debt Matters to Your Credit Score
John Ulzheimer is an expert on credit reporting, credit scoring, and identity theft. He has written four books on the topic and has been interviewed and quoted thousands of times over the past 10 years. With time spent at Equifax and FICO, Ulzheimer is the only credit expert who actually comes from the credit industry. He has been an expert witness in over 230 credit related lawsuits and has been qualified to testify in both federal and state courts on the topic of consumer credit.
The post Why Is Credit Utilization Such a Big Deal? appeared first on The Simple Dollar.
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