Analyze Your Debt to Credit Limit Ratio

TheStreet.com

NEW YORK (MainStreet)—Your credit card is just like the Tree of Knowledge from the Garden of Eden. You can see the unsparing credit line extended to you but really, you cannot use it all. Well, let me put it this way: you can use all of your credit, but if you do, your credit score will take a massive hit. Deceptive, isn't it? If you've been extended a $1,000 credit line, you would assume that you're fine if you stayed within that limit and paid in full each time. The reality is quite different, because there's something called debt-to-credit limit ratio.

Debt to credit limit ratio

"Your debt-to-credit limit ratio is one of the most important measurements in your credit scores," explained John Ulzheimer, president of consumer education at SmartCredit.com. It's easy to calculate: divide the aggregate outstanding balance of all your credit cards by the total credit limit across all the cards.

The ideal ratio?

"According to VantageScore Solutions, the creators of the VantageScore credit score, you are going to want to keep that percentage to below 30%," Ulzheimer said. "According to FICO, the creators of the FICO credit scoring system, consumers with the highest FICO scores have an average debt to limit percentage of 7%. The lower the better regardless of the credit score type."

Now, the important thing to understand here is at what point of time in your credit card cycle this ratio is calculated. "The debt to limit ratio is calculated based on what's reported to the credit bureaus," Ulzheimer said. "And, what's reported to the credit bureaus is your balance based on your most recent statement."

What this means is that if you had a card with a limit of $1,000 and the balance for your statement of May 2013 was $800, your debt to credit limit ratio will get reported at 80%. It does not matter if you paid the balance in full the day after the statement date.

Stay ahead of those credit bureaus

This ratio can be tough on those with lower limits. If you have a low credit line limit of $500, say, it can be frustrating to pay off just to spend another $500. Consumers in such a situation are just trying to earn points and build credit. But in this scenario, to keep the ratio under 30%, it means using only $150 of the limit.

If you're in the same boat, don't lose heart. Here are a few tips that can help.

First, pay off balances before your statement is generated. "If you want to truly control that percentage and keep it low then you'll need to either limit your use of the card or pay off the balance online before your statement is generated," Ulzheimer advised. "You know when your statement closing date is. And, because you know that date you can pay your bill online before the statement closing date, ensuring the credit bureaus receive a statement showing a $0 balance, or a lower balance depending on how much you paid toward your balance."

"Another way to give yourself a little insurance is to keep one or two cards open and rarely used. The unused credit limit will help keep your debt to limit percentage lower," he added.

Myth buster

You may have heard this common misconception about your credit limit: if you keep maxing out your credit card limit, it's a strong case for the issuer to increase your limit. That's possible, but it's not a rule. "Some people might even have their credit limit lowered or their line canceled for maxing out their card all the time," Ulzheimer warned. "It's all about the risk you pose to the issuer. You get away with more if you're a low risk."

So your credit card need not become a forbidden fruit. With a little bit of caution and a good measure of discipline you can enjoy the fruit and yet stay away from sin.

--Written by Deepa Venkatraghvan

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