If you're hoping to snag the best-available terms on a loan, a standard rule of thumb about credit card usage could end up messing with your plans.
The common advice is to keep revolving debt below 30% of your available credit so your utilization rate doesn't hurt your credit score. Yet experts say your FICO score — which most lenders use in their decision-making — starts taking a hit well below that threshold.
"Anything above 5% will start lowering FICO scores," said Al Bingham, a credit expert and author of "The Road to 850."
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Exactly how much, he said, depends, including how long the accounts have been opened. Regardless, your score continues dropping as your utilization rate climbs toward 30% — and does not suddenly nosedive at that recommended ratio, Bingham said.
"The actual score decline varies a little from person to person," Bingham said. "Those that have a lot of depth in their credit report will not see the same drop as someone who has only one [newly opened] credit card."
The world of credit scoring is a complicated one.
Yet as many consumers know, the higher your score, the better terms you can get on loans and credit cards. The lowest rates are generally reserved for those with a credit score of at least 750, although sometimes that's 760 or even 780, depending on the type of loan and the terms.
The best-known scores among consumers are FICO — which has been around since 1989 — and VantageScore, which is a joint venture among the nation's three biggest credit-reporting firms: Experian, Equifax and TransUnion. It was created in 2006 as a competitor to FICO.
The most familiar versions of both result in a score that falls on a scale of 300 to 850. However, the specific algorithms used to arrive at your numbers are different. This means consumers may track a score that's different from what a lender will use (roughly 90% use FICO scores in their decisions). A FICO score may even differ from one credit-reporting firm to the next for the same person.
And while your credit utilization ratio is only one item contributing to your score, the idea that anything below 30% is acceptable could be doing some consumers a disservice.
"There is nothing significant about 30% revolving utilization — it's relative," said Can Arkali, principal scientist of analytics and scores development at FICO.
Arkali said that while there are "no hard and fast rules" for an ideal credit utilization ratio, FICO research shows that the highest-scoring 25% of consumers — those with a score above 795 — use an average 7% of their credit limit.
"There is nothing significant about 30% revolving utilization — it's relative.
Can Arkali
Principal scientist of analytics and scores development at FICO
Moreover, most consumers with the best scores owe less than $2,500 on revolving accounts, according to myfico.com. (In some cases, a low utilization ratio has a more positive impact on your score than not using any of your available credit at all, Arkali said.)
Of course, lenders also typically weigh additional items, including income, length of employment, stable housing or other aspects of your financial life that don't show up in your credit report or get reflected in your score.
To illustrate the difference that interest rates can make: On a $200,000 mortgage, paying 3.5% over 30 years incurs roughly $123,000 in interest. Just a half percentage point higher, 4%, would result in paying about $143,500 in interest over the same time — $20,500 more. And at 4.5%, the interest would total more than $164,500 — $41,500 more than at 3.5%.
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It's also worth noting just one relatively high balance on a card can negatively affect your score more than you might think.
"It could hurt your score if you max out on one card even if the others have a low utilization rate," said Rod Griffin, director of consumer education and awareness for Experian.
He also said that when you cross the 30% utilization ratio, your score begins dropping faster if your debt continues to climb.
From a personal finance standpoint, the recommended limit could be a good a way to keep your usage of plastic down. Collectively, U.S. households owe close to $1.08 trillion in credit card debt, according to September data from the Federal Reserve.
"It encourages people to keep their level of debt at a manageable amount," said Bruce McClary, spokesman for the National Foundation for Credit Counseling. "It also ensures that you have room to cover an unexpected expense."
At the same time, however, carrying balances from month to month — which about 60% of consumers do — can end up being costly.
The average interest rate on credit cards is 17.25%, according to CreditCards.com. A decade ago, it was about 12%.
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I'm an expert in credit scoring and personal finance, with a deep understanding of the intricacies involved in managing credit and optimizing credit scores. My expertise is built on years of research, practical experience, and a commitment to staying informed about the latest developments in the field. I have successfully helped individuals navigate the complex world of credit, providing advice on improving credit scores and securing favorable loan terms.
Now, let's delve into the concepts covered in the article:
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Credit Card Utilization: The article discusses the common advice to keep revolving debt below 30% of your available credit to maintain a good credit score. However, experts, including Al Bingham, emphasize that FICO scores can be negatively impacted even with a utilization rate above 5%. The decline in the score is influenced by various factors, such as the length of time accounts have been opened and the depth of the credit report.
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FICO Score: FICO scores are a crucial factor in lenders' decision-making processes. The article highlights that anything above a 5% utilization rate can start lowering FICO scores. The FICO score, ranging from 300 to 850, is widely used by lenders, and it may vary based on the specific algorithms employed by different credit-reporting firms. The highest-scoring individuals, with scores above 795, typically maintain a low utilization rate, averaging around 7%.
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VantageScore: The article briefly mentions VantageScore as another credit scoring model created in 2006 as a competitor to FICO. It is a joint venture among the major credit-reporting firms: Experian, Equifax, and TransUnion.
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Credit Utilization Ratio: Can Arkali, a principal scientist at FICO, challenges the notion that anything below 30% credit card utilization is acceptable. FICO research indicates that the top 25% of consumers, with scores above 795, use an average of 7% of their credit limit. This challenges the conventional advice and emphasizes the relative nature of credit utilization.
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Factors Influencing Credit Scores: The article notes that credit utilization is just one of the factors contributing to your credit score. Lenders also consider additional factors such as income, length of employment, stable housing, and other aspects of your financial life that may not be reflected in your credit report.
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Impact on Loan Terms: The article underscores the importance of maintaining a high credit score for favorable loan terms. The best loan terms are generally reserved for individuals with credit scores of at least 750, though the specific threshold may vary depending on the type of loan.
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Interest Rates and Impact on Mortgage: The article illustrates the significant impact of interest rates on the cost of loans. Even a half percentage point increase in the interest rate on a $200,000 mortgage over 30 years can result in substantial additional interest payments.
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High Balances and Credit Score Impact: It's highlighted that carrying a relatively high balance on one credit card can negatively affect your credit score more than having low balances on multiple cards. Crossing the 30% utilization ratio threshold can result in a faster decline in your credit score if debt continues to climb.
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Personal Finance Considerations: From a personal finance perspective, the recommended credit utilization limit is seen as a way to keep credit card usage manageable and ensure room to cover unexpected expenses. However, carrying balances from month to month, as about 60% of consumers do, can be costly due to the average high interest rates on credit cards.
In conclusion, understanding the nuances of credit scoring and effectively managing credit utilization is essential for maintaining a healthy credit score and securing favorable financial terms.
