I'm always trying to crack the credit-scoring code that plays a big role in determining how much consumers pay for the money they borrow.
So I was eager to dig up an answer to a question I received from a reader recently. She wrote: "In your column, I have read that if you use over a certain percentage of the credit on your credit cards, it will lower your FICO score. My question is this: Is it a certain percentage of your credit-card credit overall or a percentage of your credit on a particular card?"
The credit-scoring algorithm looks at the credit utilization rate for each active account and, separately, a person's credit usage for several accounts together, said Craig Watts, public affairs manager for Fair Isaac Corp., the company that created the FICO credit score used by many lenders to evaluate consumer credit risk.
According to Watts, here is what's factored into your credit score:
* Your credit utilization for each active revolving account, such as credit cards and some home equity lines of credit.
* Credit utilization across all active revolving accounts.
* Credit utilization for each active installment account you have, such as a mortgage, auto or student loan.
* Credit utilization across all active installment accounts.
"We have found that both factors -- individual credit utilization and aggregate credit utilization -- have value in predicting future credit risk," Watts said.
Here's a practical example of what Watts is saying: Let's say you have four active credit cards, each with a credit limit of $5,000. Three of the cards have zero balances. The fourth card has a balance due of $5,000, making you maxed out (100 percent credit utilization). Being maxed out on that card will hurt your credit score.
However, your overall utilization for all four cards is just 25 percent, which is good and would probably help your score. An even lower utilization rate would help your score even more. Generally, you don't want to use more than 50 percent of the available balance on any one card, and you don't want the combined utilization to be more than 50 percent.
In addition, Watts said, the FICO scoring model gives more weight to your credit usage on revolving accounts than on installment accounts.
"People have more flexibility with borrowing and repaying money to revolving accounts, so their activity on those accounts is more indicative of their money habits and more predictive of future behavior," he said. "Installment loans require payment of the same amount month after month, so while that activity is predictive, it isn't as valuable to FICO scores as activity on revolving accounts."
Now what if, on occasion, you max your card, or come close, to make a large purchase? Sometimes I do this if I'm buying a household item such as a couch. I pay the bill off the next month, but the purchase can take me close to my credit line.
Well, your score will recover fairly quickly once the credit report reflects that the card bill has been paid down, Watts said.
Keep in mind, he added, that your credit score is based on what's reported in your credit file the moment that the score is calculated. So it may be a few days or weeks before you see your score increase after paying off your bill.
And exactly how much does maxing out hurt your score?
About 30 percent of a typical person's credit score includes the following factors:
* Amount owed on accounts.
* Amount owed on specific types of accounts.
* Lack of recent account activity. (This may mean that you have no open revolving accounts, that you haven't used a revolving account in a while, or that your balance information is not being reported.)
* Number of accounts with balances.
* Proportion of credit lines used (proportion of balances to total credit limits on certain types of revolving accounts).
* Proportion of installment loan amounts still owing (proportion of balance to original loan amount on certain types of installment loans).
Watts said it's important to note that someone who has only one credit card account -- no loans, no other credit accounts reported to the bureaus -- would find that her credit score would suffer more when her credit report shows that her card is maxed out. However, someone with several active credit cards who has not missed a payment for many years and who typically keeps low balances on her cards won't get hit so hard if occasionally she maxes out.
"In the first woman's case, the algorithm has less information to look at, so there is less good information to contribute to her score and counterbalance the likely loss in points from maxing out her account," Watts said. "In the second woman's case, her credit report has more information for the algorithm to analyze, including information reflecting good credit management that will help raise her score."
So remember, one way to maximize your credit score is by minimizing your utilization of your revolving credit accounts. And we all could benefit financially if we keep in mind what Canadian media critic Marshall McLuhan said: "Money is a poor man's credit card."
* On the air: Michelle Singletary discusses personal finance Tuesdays on NPR's "Day to Day" program and online at www.npr.org.
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