Consumers use credit in a variety of ways. When a lender extends credit to you, that credit account is reported to the credit bureaus. Such information is distilled into a credit report. According to MyFico, your FICO credit score ranges from 300 to 850 and is directly based upon the data in your report. It's important to understand how debt impacts this score.
Identification
Your FICO credit score is determined by a mathematical algorithm that translates the data on your credit report into a three-digit number. The score looks at five areas: 35 percent is how well you pay your bills, 30 percent is how much debt you have, 15 percent is the average length of your credit history, 10 percent is the amount of new credit you've applied for recently, and the last 10 percent reflects the mix of credit found on your report.
Significance
The second largest factor in your credit score is how much debt you have. For this factor, FICO measures your debt-to-credit ratio, also known as your credit utilization ratio. In essence, this compares how much debt you have versus how much available credit you have. The more available credit you have, the lower this ratio and the higher your score. Conversely, the less available credit you have, the higher this ratio and the lower your score.
Considerations
How you use your credit cards can directly affect your FICO credit score. Since your FICO score measures your credit utilization ratio, maxing out a credit card will decrease your credit score. The reason is because if you use up your entire credit limit, that decreases your available credit while increasing the amount of your debt. According to Bankrate.com, a maxed-out card can lower your score by up to 45 points. A lower credit score can put you at risk for higher interest rates on other types of credit that you apply for.
Prevention/Solution
Lowering the amount of debt you have will gradually increase your score. According to MyFico, to improve your score you should keep balances on revolving credit, such as credit cards, low. Pay down the debt instead of using balance transfers. Transferring the balance doesn't eliminate the debt; it simply moves it around from one card to another. Decreasing the number of credit accounts that you have without decreasing the amount of debt may actually lower your score, according to MyFico.
Warning
Be careful when closing credit cards. Remember, 15 percent of your FICO score measures the length of your credit history. Closing a card, especially an old credit card, will shorten the length of your credit history, and that may lower your score. The longer your history is, the higher your score. Also, according to MyFico, don't open new credit accounts just to increase your available credit and improve your score. The opposite may happen because each new account decreases the average length of your credit history and this may drop your score. How much it drops depends upon the other factors present within your report.
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