FICO scores are formulated using a complex algorithm that factors in many elements of your credit history. You FICO score is a snap shot of your credit standing and is based off of your credit report. There are five main elements of your FICO score that each has a different weight: payment history 35%, how you owe 30%, credit history 15%, applications for credit 10%, and credit mix 10%. Besides your payment history, how much you owe is one factor that keeps consumers from getting a good FICO score.
Why is how much owe have such a large weight in a FICO score? It reasoning is based on the high default rate of consumers that are near their limit in credit. Consumers that are near the limit have little room for error. Things like an interest rate hike or loss of a job can cause consumers to default. Also, it is a sign of lack of control in ones finances and if struggling here it could be one of many other problems in a person’s finance.
One term is usually used when discussing how much you owe in calculating your FICO score, “utilization.” This is the difference between how much you owe on your accounts and the total credit limit. Utilization is actually a ratio mathematically stated as how much you owe divided by the credit limit. This is done on an account by account basis as well as an over all rating. The rule of thumb is the lower the utilization the better.
There are more complex aspects of how much you weighted into your FICO score. The first is the fact that is done on an account by account basis. It is better to have you utilization spread among several different cards compare to just one. So if you have a credit card that is close to the limit and several that have zero balance, this could hurt your score. This is often the case when consumers are doing balance transfers to pay off a high rate card.
The second point to consider is if you close account with zero balances you could hurt your FICO score. Since your utilization is also figured as a sum of all your accounts, closing accounts will hurt your total amount of credit. Since you divide how much you owe by your total credit limit, lowering your total credit will make your utilization rise.
As you decide to pay down debt to lower you utilization you might find that your will find your FICO score will not improve over night. This is because after paying off a balance it must be reported to the credit bureaus and then added to your credit report. This will take time and you will just have to wait. The moral is paying down how much you owe is one of the most difficult and influential actions you can do to improve your FICO score.
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