About 30 percent of your credit score is determined by the amount of money you owe creditors. This component takes a look at two things:
- The amount of money you owe on a loan compared to the amount you originally owed.
- Your utilization rate.
Let’s take a look at these factors.
Outstanding Debt Factor #1: The amount of money you owe compared to the amount you originally owed.
The credit-scoring models respond more favorably when you are invested in a loan. For this reason, new loans usually hurt your credit score. The damage is temporary–your score will start to recover once you have made about six monthly payments.
The credit-scoring models know that you are less likely to default on a loan if you have money invested into the loan. Let’s say, for instance, that you have paid $19,000 of your $20,000 car loan. If your car will be paid in full in just three or four months, you are much less likely to default than someone who has paid only $1,000 of a $20,000 car loan. Ergo, the more you have paid, the higher your score.
Outstanding Debt Factor 2: Your utilization rate.
The credit-scoring bureaus take a look at the utilization rate on each credit card you carry. The utilization rate is the balance of your credit card expressed as a percentage of the limit. If you have a $700 balance on a credit card that has a $1000 limit, then that credit card has a 70 percent utilization rate. As you might guess, the credit-scoring models worry more about higher utilization rates than they do about lower utilization rates.
Ideally, you should try to keep your utilization rate at 30 percent or lower, month-round. Having a higher utilization rate tells the credit-scoring models that you might be overextended, and that you might make a late payment soon.
Keep in mind, too, that you should keep your utilization rate below 30 percent on each and every card, and that you should keep this balance month-round. When it comes to your credit score, you are far better off spreading your credit card debt among three to five credit cards, each with a 30 percent utilization rate, than you are consolidating all debt onto one low-interest credit card with a 90 percent utilization rate.
Please, please read about the dirty little credit scoring secret that results in an increased utilization rate that lowers your credit score!
See also:
What makes up a credit score? Part I: Your payment history.
What makes up a credit score? Part III: The age of your credit.
What makes up a credit score? Part IV: The type of credit you have.