Do you have a good credit score? Or have you even seen yours recently?
Your credit score used to be almost impossible to get unless you are willing to pay for it. FICO, the company that invented credit scoring, still charges for theirs.
However, it’s now possible to get something equivalent to your FICO score free from a number of different sources. You can get yours free on CreditKarma or CreditSesame. The Discover Card will also provide your credit score free even if you’re not a customer. We get ours each month on our Chase Freedom credit card statement.
Why is it important to know your credit score?
It’s important because it can be either an asset – that saves you money – or a liability that’s costing you money in the form of higher interest rates and even higher insurance premiums.
The single biggest factor
There are five components used in determining your credit score. The biggest by far is paying your bills on time. In fact, this accounts for 35% of your credit score.
But surprise! Just making your payments on time doesn’t guarantee a good credit score. In fact, according to at least one expert you could never make a single late payment and still have a less than wonderful credit score.
The second biggest factor
The second biggest factor, which accounts for 30% of your credit score, is your credit utilization.
What, you might ask, is credit utilization? It’s a ratio that expresses the relationship between how much credit you have available and your credit card balances. It’s generally expressed as a percentage. For example, suppose you’ve charged $2000 on a credit card and your available limit on that card is $4000. This means your credit utilization ratio would be 50% so you would have used up half of the credit you have available. This is much higher than credit scoring models and lenders like to see.
Why it matters
The people who develop credit scoring models create mathematical algorithms that are used to calculate your credit score. There is one simple reason why they focus on your credit utilization: It predicts your credit risk. In other words, people that have utilized a high percentage of the amount of their credit card limits are seen by lenders as being bigger risks.
You could have a high credit utilization ratio because you suffered a reduction in your income. Or because you were out of work for a few weeks and had to charge more on your credit cards than usual.
But the reason why you have a high credit utilization ratio doesn’t really matter.
The way lenders look at it is that if you have a high credit utilization ratio you’re statistically more likely to either default or make late payments in the future. As an example of this, if you were to apply for, say, a debt consolidation loan, this would make you look less attractive to potential lenders.
An unpleasant surprise
It’s important to understand that your credit utilization ratio is the amount of credit you have available that you’re using at the specific time your credit score is calculated.
If you’re paying off your credit card balance each month thinking that this will protect your credit score, you could be in for an unpleasant surprise.
The reason why this is true is because the credit card companies only report your balances to the credit bureaus once a month and that’s shortly after your account’s closing date.
If you use up a big portion of your credit limit one month – like charging up $2000 in Christmas purchases – on a card that has a limit of just $3000 – and you pay off that balance in full before your due date but after your statement’s closing date, the credit reporting bureaus will still see your balance as $2000 with an ugly credit utilization ratio of 67%. This is despite the fact you are current. And worse yet, this will stay in your credit reports until the next month
when there is a new closing statement generated.
How to avoid this
Fortunately, it’s relatively easy to avoid this problem. All you need to do is pay a small portion of your credit card balances several times per month. This will prevent you from building up a high balance.
Of course, the best strategy still is to pay off your credit card balance prior to your statement closing date. This will guarantee your credit utilization percentage will be zero, which will be great for your credit score.
How to improve your credit utilization ratio almost immediately
Could you pay down some of your credit card balances while eliminating others entirely? If you can do this, you should see your credit score begin to improve almost immediately.
The first ones you should pay off are those of your accounts with low balances. These are sometimes called “nuisance” balances. Paying them off should also improve your credit score almost immediately.
The next thing you will have to do is tackle those credit card debts with the high balances. This will take some time. The good news is that even though it will take time to pay down those balances, your credit utilization ratio will go down while you’re doing it. A credit utilization of 50% is still better than 60% and 30% is better than 50%. It just boils down to the lower the better.
If you’re stuck
If there is a good reason why you can’t pay down some of your credit card debts very quickly, there is an alternative.
You could get some new credit.
Getting back to our example of having charged $2000 on a $4000 credit card, which yields a credit utilization ratio of 50%, you might be able to get a loan for $2000. You would then immediately have a credit utilization ratio of 33%, which would look much better to potential lenders. Of course, you would not want to use that money to pay for anything because that could just cause your credit utilization ratio to go back up.
Here’s a short video that explains more about the relationship between credit utilization and your credit score and includes an example of why it’s best to pay off one of three credit cards first.
