Clients ask me every day what they can do to improve their credit score besides removing negative items from their credit report. The conventional advice is not to open additional lines of credit, not to close existing accounts, and to pay everything on time. A little known fact is that understanding your credit utilization ratio (debt to credit limits) can create a favorable credit profile for you.
Please understand that your credit score is a three-digit number that has become increasingly important to your life. Loan terms, insurance rates, job offers, utility deposit requirements, tenant selection, etc., are based on that number. When credit score is mentioned most often, it refers to the secret algorithm that Fair Isaac’s Corporation, FICO, uses to calculate your score. A little-understood component of that score is your debt or credit utilization ratio. That ratio makes up about 35% of your score, so it’s very important to manage it in the best way possible.
Your debt-to-credit ratio is simply the amount of revolving (credit card) debt you have outstanding compared to your credit limit on those credit cards. A person who has $2,500 in balances and a credit limit of $10,000 has a 25% ratio. Your score is determined not only by the total amount of outstanding debt, but also by the individual amount loaded on each line of credit. Today, the number that most credit experts consider to be the same or lower is 30% of your credit limit. That means with $10,000 in credit limits you don’t want to have more than $3,000 outstanding.
One more secret about using credit cards is that you don’t want to carry ZERO balances, close cards, and never use credit. Lenders want to see you use credit responsibly. That doesn’t mean going into debt, but I advise customers loading up on groceries, gas, or other essentials to buy over the course of the month and pay most or all of it when the bill comes. Although it makes financial sense to pay in full and pay no interest, lenders like you to carry balances. So if you’re a pay-as-you-go person planning to apply for a mortgage or other loan, you may want to rotate the use of all your cards and position yourself as a favorable credit risk starting a few months before you do. Seek loan approval.