Obtaining a credit score above 750 makes life cheaper. You will be able to obtain mortgages and auto loans at the lowest possible interest rates. Having a good credit score can even be more important than avoiding a DUI to get the lowest auto insurance rates. In recent years, many very smart people have been working hard to find alternatives to credit scores. But, for the time being, our financial lives still depend largely upon the algorithm built by FICO, and imitated by many others. So it makes sense to have a good understanding of how scores, in general, are calculated.
The most important part of any credit score is making payments on time. FICO has revealed that 35% of your score is determined by your on-time payment history. Becoming 30 days or more delinquent just one time can take over 100 points off your credit score. So the rule is simple: always make your payments on time.
The second most important part of a credit score is the amount owed, which represents 30% of the score. According to FICO, "owing money on credit accounts doesn't necessarily mean you're a high risk borrower. However, when a high percentage of a person's available credit is used, this can indicate that a person is overextended and is more likely to make late or missed payments."
FICO, and other generic credit scores, usually differentiate between "good debt" and "bad debt." Good debt is a fixed term installment loan, often used to purchase an asset. For example, a mortgage or auto loan would be looked at kindly by credit scores. However, credit card debt can very easily get your score into trouble. The score will look at both the total amount of credit card debt that you have, as well as your credit card utilization rate. Utilization is defined as the percentage of available credit that is used. For example, if you have a credit card with a $100 limit, and have a $20 balance, you will have used 20% of your available credit.
Recent data released by Experian Decision Analytics shows just how powerful utilization can be in your credit score. Super-prime customers, defined as people with a VantageScore (similar to FICO) above 780, use only 5.6% of their available credit on average. Prime customers, with scores between 661-780, use 27.5% of their available credit. And subprime customers, with scores of 500 – 600, use 77.2% of their available credit. From this data it is easy to see that people with higher utilizations have lower credit scores.
Why is utilization such an important indicator of credit risk? People with high levels of utilization tend to have lower credit scores because they are willing to engage in three types of risky behavior.
1. They Borrow A Lot Of Money, Relative To Their Income
When you take out a credit card, you are often given a credit limit that is greater than you monthly gross income. People who max out their credit cards are usually spending more than their monthly pretax earnings. The data shows that borrowing money for a planned purchase is not high risk activity. For example, purchasing a home represents an investment in the future. However, credit card purchases are usually not investments. Maxing out credit cards demonstrates an inability to live within economic means.
2. They Pay High Interest Rates For Discretionary Purchases
Credit card interest rates tend to be high. In a survey by MagnifyMoney (my website), 76% of people with credit card debt indicated that their interest rate was above 15%. Most people would not plan to borrow money at 15% to finance restaurants, groceries or gas purchases. If you are willing to pay an interest rate that high for discretionary expenses, it signals either a lack of financial control or a difficult financial situation.
3. They Use Credit Whenever It Is Available
If you max out every credit card that you are given, it shows a lack of self-discipline. Statistically, people who use all available credit are likely to borrow beyond their capacity to repay.
So What Should I Do?
The extreme cases are easy to diagnose. If you have maxed out every credit card, you will likely have a low credit score. Equally, if you have used less than 5% of available credit on all of your credit cards, you could have a great credit score, so long as you make your payments on time.
But many people worry about where to draw the line. According to the VantageScore data, prime customers have utilization below 30%. As a general rule, I advise people to never spend more than they can afford to pay off, in full, every month. And that number is usually below 20%. If your credit limits are low, relative to your current income, you should ask for a credit line increase or open a new card. In general, spending more than 20% of your available credit indicates a risk of falling into high cost credit card debt. If you need to borrow, you should consider a low interest rate personal loan, planned and negotiated in advance. Your credit score and your wallet will thank you.