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Credit scores are an enigma. Tiny bots comb the details of our borrowing habits and report back to this mythical “Black Box” which cranks out a number by which Financial Institutions can judge us. Sounds scary right? In all my years of mortgage lending, the question I was asked most, by far, was “Can you tell me what my credit score is??” Credit scores scare the shit outta people.
Now while the credit agencies (Equifax, Transunion and Experian) have kept secret their exact recipes, most people know there are a few basics to having a great credit score; pay your bills on time and don’t file for bankruptcy. Sure, if you nail those two you’ll probably end up with a decent credit score.
But THE BIGGEST mistake that keeps people from having a GREAT or PERFECT credit score (760+) is this:
CONSUMERS DON’T UNDERSTAND THE CREDIT UTILIZATION RATIO
What the “Credit Utilization Ratio” is and how it’s calculated isn’t the most easily understood concept but since it can account for about 30% of the overall credit score, you better LISTEN UP!
The Credit Utilization Ratio is the sum of all outstanding balances on all revolving accounts (i.e. credit cards) divided by the sum of the total credit limits on those accounts (measured as a percentage.) So for example, if the only credit card you have is a Capital One card with a $3,000 balance and a $10,000 credit limit, your Credit Utilization Ratio would be 30%. If you had a $5,000 balance, your Ratio would be 50%. The lower the ratio, the higher the credit score, with the theory being that people with higher ratios are more likely to struggle with managing their debt-load.
“But I pay my credit card off each month so it doesn’t matter!” Wrong genius. Traditionally what the creditor reports to the credit bureau is the “statement balance” so if that credit card statement shows a balance of $2,500 against your $10,000 limit, your utilization ratio is 25%. Oh you paid the entire balance off a few days later? Credit score don’t care. Credit information is only updated by the creditor once per month, so that zero balance will probably never show on the credit report, because you’ll spend up another $2,500 through the course of the month because you “like to get the airline points.”
You’ll start losing a few credit score points when that Credit Utilization Ratio exceeds 5%, it starts to get significant around 30%, and once you get over 50% you can really see major decreases in credit score.
To put that into perspective, say someone had a 720 credit score and their Credit Utilization Ratio was at 5%. If they made a large credit card purchase (even if they intended to pay it off at the end of the month) and the Utilization Ratio went over 50%, that persons score could easily drop to 675. If a bank pulled their credit in order to price a mortgage, the drop in credit score could easily add an additional .5% to the APR of the loan, making that loan tens of thousands of dollars more expensive (that’s a lot of airline points.)
There are a couple of different ways to deal with this.
1. If you’re planning on applying for a mortgage, home equity loan or car loan, try to pay down credit card balances down AT LEAST ONE MONTH beforehand in order to allow those balances to reflect accurately on the credit report.
2. Don’t close unused credit cards. You can see in the above examples, there wouldn’t be an issue if the consumer had $100,000 in available credit on credit cards that they weren’t using. Unfortunately, there’s an “old wives’ tale” floating around that people believe open credit lines are a bad thing for credit scores. This could not be more untrue.
The key here is to understand what your own personal numbers look like and take measures WELL BEFORE the need for credit arises. Once the lender pulls a credit report, you’re kind of stuck with that score for the credit application, and they won’t allow you to pay things off in order to manipulate the score.
Patrick O’Brien is a mortgage banker turned software entrepreneur at LenderLogix. With QuickQual by LenderLogix, your borrowers and Realtors can issue their own pre-qualification and pre-approval letters. Intrigued? Learn more now.