Personal Finance Advice

We are under constant media barrage about checking our credit report and we all know it’s important to have a high credit score. With the new legislation, it’s possible that a great credit score will be more important than ever. But does the average Joe really understand what goes into the calculating of a credit score? I know I didn’t until I started researching it.

I was surprised to find out that your debt to limit ratio has a 30% impact on your credit score. Only your credit history has a higher effect on your credit score.

Debt to income ratio is sometimes called debt utilization. Basically, it is the percentage of overall debt you owe compared to the total amount of your available credit lines (not the amount of credit that you have).

Let’s say you have several credit cards and your total available credit line is $100,000. Now you have shown tremendous restraint and only owe $10,000 on those cards. So you are using 10% of your available credit line. Anything under 30% debt utilization is considered very good and will help you attain a high credit score. But, if you had loaded those same cards up with $80,000 worth of debt, you would be at 80% debt utilization and negatively considered a credit risk.

There are some things you can do to increase your debt to limit ratio. The most obvious is to pay down your debt. However, one thing consumers often do as soon as they pay off a balance on their credit card, is close the account. This may not be in your best interest if you are trying to raise your credit score. Closing an account lowers your total available line of credit. If you leave the account open with a zero balance, the credit scoring system thinks you are a financially responsible individual because your debt to income ratio is low.

There is a lot of controversy over closing unused credit card accounts. Some financial gurus are adamant about it. They say you should close the account so you won’t be tempted to overspend. But the truth is that you need to decide for yourself whether this will fit into your financial goals. If you are going to purchase a house or car anytime in the next year or so, you may need to depend on a high credit score and closing unused credit lines can lower your debt to income ratio.

You should also be aware that if you are debt free and have no line of credit open to you, your credit score will be lower than someone who has a small amount of debt and larger lines of credit. Of course, if you are debt free and have a million dollars or so in the bank, you won’t have to worry about your credit score or debt to income ratio.

Another way to lower your debt to limit ratio is to increase the amount of your credit lines. You can do this by calling your credit card company and asking them to raise your credit limit. Be sure to ask them if they can do this without pulling a new credit report on you. Credit inquiries constitute 10% percent of your credit score. Then, after they raise your limit, don’t spend any extra. Try to keep your balances low and spread out across several credit lines. Don’t go overboard when asking for increased credit lines. A high credit limit can be viewed as possible debt and has the potential to count against you.

The thing to remember about your debt to limit ratio is that the credit scoring system doesn’t look for a specific dollar amount. They look at how much debt you have, compared to how much credit is available to you.

How important is your debt to limit ratio? That depends on where you are in your financial life. Do you want to buy a house someday? Do you expect to pay cash for that house or are you going to need to finance it? I don’t know anyone who can afford to pay cash for a house. Whether we like it or not, having a good credit score has become an integral part of our financial lives. Since your debt to income ratio is a significant part of your credit score, it must be considered very important.

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