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Credit Utilization and the Impact on your FICO score




Credit utilization and your FICO score

Your FICO score is based on five key elements: your payment history (35 percent), the length of your credit history (15 percent), your credit mix (10 percent), how much new credit you have (10 percent), and the total amounts you owe (30 percent).

The amount you owe, or how much credit you’re using—also known as credit utilization, comprises almost one-third of your credit score. And though it may seem straightforward, some nuances are often overlooked.

In addition to representing the total amount of your outstanding credit, credit utilization is also a marker on your ratio of outstanding debt relative to your current credit limit.

Installment and Revolving Credit

To understand why this is so important, it’s good to review both installment credit and revolving credit.

Installment credit is a term loan with pre-determined payments, such as a mortgage, car or student loan. It’s also like a traditional term business loan, in which you receive a lump sum and agree to pay back that amount plus interest in specific increments over a set amount of time.

In relation to your credit utilization with a term loan, your utilization ratio (or the ratio of the amount you owe) will be very high at the start of the loan. But, as you make payments, your utilization ratio will decrease over the life of the loan, as you owe less over time. Your FICO score is generally less affected by installment credit then it is with revolving credit.

That’s primarily because, with a revolving credit account, as you pay back the amount you’ve borrowed, you are able to borrow those same funds again within your pre-approved credit limit. This is similar to a line of credit or credit card.

If you have a credit card with a $10,000 limit, and you spend $5,000—you have a 50 percent credit utilization ratio, since you’ve used 50% of the credit. For each $1,000 you repay, you decrease your utilization ratio by another 10 percent. But if you spend $1,000, your utilization ratio goes up 10%. You can see in this scenario that if you’re spending outpaces your payments, your utilization ratio could increase quickly, negatively impacting your FICO score.

What Should You Do To Keep Your Credit Report Favorable?

With your credit report being very essential to establishing your financial reputation, you must do what you can to keep it as clean and favorable as possible. Paying your bills on time, preventing debts from mounting up, and basically handling your finances well are just few of the things that you can do to keep your record untarnished. 

If you realize that upon checking your credit report, there might be some errors in it, make sure that you exhaust all means to correct it as this can reflect badly on you. Sometimes these errors may come because of innocent technical mistakes through your banks, and sometimes they may come with much serious threats as having people steal your credit identity.  In such cases, contact the credit bureau and report your concerns as well as correct errors by approaching the source of your report. 

Credit reports may be just as important as your passport, birth certificate or any other legal records. It helps establish your financial identity and reputation, and may prove to be very useful not only for you to handle your personal finances well, but even in your business finances. 

In trying to do transactions that may involve money and credit with other people, this will be one of the very crucial things examined. And so, make sure that you manage your record well and keep it as spotless as possible.

Charles Colbert is the Managing Director of iSmallBizCredit and Ismallbusinesscredit.com. Prior to iSmallBizCredit, Charles worked at American Capital Group and began his career at Bank of America Credit Card Marketing Division. Charles is the author of Building Business Credit See How Your Business Can Grow! And coming soon, the new E book: How to Start a Business Credit Profile. 

Website: www.ismallbusinesscredit.com
LinkedIn:  www.linkedin.com/in/ismallbiz
Facebook Fan Page: www.facebook.com/pages/Ismallbusinesscredit
Twitter: @ChazzScot



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