U.S. Markets closed

How Your Debts Affect Your Credit Score

Matthew Frankel, CFP, The Motley Fool

You might be surprised at the way your debts impact your credit, and how you can boost your credit score by knowing how it works.

Man in suit running from a wrecking ball labeled Debt.

Image source: Getty Images.


Your debts are a big component of your credit score. For example, most people know that all other things being equal, the more money you owe, the lower your credit score. However, the way it works is far more complex than generalizations like this.

With that in mind, here’s a rundown of how your debts affect your credit score and how you can use this information to your advantage to maximize your score -- even if you can’t pay down your debts right away.

The FICO credit scoring formula

The precise formula used to calculate the FICO® Score is complex and, unfortunately, a well-guarded secret. There's no way to know exactly how much of an impact a certain credit behavior -- say, paying down $1,000 of your credit card debt -- will have on your score. Any FICO scoring calculator you may have found online is an estimate. Some are rather accurate, but they're still educated guesses.

Fortunately, we do know some details about how FICO® Scores work. Specifically, we know that FICO® Scores are made up of five different categories of information, and that each category carries a specific amount of weight in the overall formula. We also know that FICO® Scores range from a low of 300 to a maximum "perfect score" of 850, and anything above 740 is generally considered to be a very good credit score.

Here's a high-level overview of the five FICO credit scoring categories and how much weight each one carries:

  • Payment history (35% of your score) -- This category takes into account whether or not you pay your bills on time. There isn't really too much to this category, but it's the single most important factor in the FICO formula.

  • Amounts owed (30% of your score) -- This includes information such as the actual dollar amounts you owe, as well as things like how much you owe on loans compared to their original balances and how much you owe on your credit cards relative to your limits.

  • Length of credit history (15% of your score) -- The longer your credit history is, the better. This category looks at your overall credit history, as well as your individual credit accounts.

  • New credit (10% of your score) -- Studies have shown a clear correlation between the number of recently-opened accounts and recent credit applications and default rates. This is why any new credit activity you have gets its own category.

  • Credit mix (10% of your score) -- This one may sound strange, but it can help your score to have a nice variety of account types on your credit, such as mortgages, auto loans, and credit cards. The idea here is that creditors want to see that you can be responsible with all different types of credit -- not just one or two.

For our purposes, the takeaway is that there’s only one category that considers your actual debts: amounts owed. The rest have to do with particular credit behaviors, such as paying your bills on time and opening new credit accounts.

The “amounts owed” category: What it includes, and what it doesn’t

Despite what the name might suggest, this category doesn't necessarily refer to the actual dollar amounts you owe on your various credit accounts. In other words, a $200,000 mortgage balance isn't necessarily worse than a $100,000 mortgage balance, and $10,000 in credit card debt isn't necessarily worse than $500 in credit card debt.

Rather, the primary factor this category considers is how much you owe relative to your available credit, and how much you owe relative to your original loan balance. This is the more important factor in the eyes of creditors -- after all, if you're using 90% of your available credit, for instance, it is a good sign that you might have let your debt get a bit out of hand.

Experts generally suggest that you aim to keep your credit utilization under 30%, and lower is definitely better -- to a point. As I've mentioned several times, the precise FICO formula is unknown, but the general consensus is that a small balance is better than no balance.

The FICO formula takes several different metrics into account in the "amounts owed" category. It looks at:

  • Your overall credit utilization on all of your revolving credit accounts. For example, if you have four credit cards each with a $5,000 credit limit, and you owe a total of $2,000, you are using 10% of your overall available revolving credit.

  • The utilization on individual revolving credit accounts. If all $2,000 is on one of your credit cards, that account would have a 40% utilization percentage.

  • The amounts you owe on installment loans relative to your original balances. In the eyes of the credit bureaus, having paid down a large portion of your existing loans is a good sign of financial responsibility. For example, a $200,000 mortgage balance on a $500,000 original loan amount would generally look better in the FICO formula than a $100,000 mortgage balance on a $150,000 original loan balance.

  • It’s also worth noting that installment debts, like mortgages and personal loans, are generally considered more favorably than revolving debts like credit cards.

  • How many revolving accounts you have with balances. This is one of those risk factors that has been statistically verified, and therefore is a part of the scoring formula. Even if your credit utilization is very low, small balances on several different accounts may be worse than if all of those small balances were just combined on the same account.

Strategies to maximize this part of your FICO® Score

Paying down your debts is the most obvious way to improve this portion of your FICO® Score. For example, experts generally suggest that you aim to keep your credit card utilization below 30%. Lower is better, but the general consensus is that a small amount of credit card utilization is better than none at all.

However, that’s just one way you can strategically use this category to maximize your score. Here are a few more ways you can potentially improve the impact of your debts on your FICO® Score:

  • Ask your credit card issuers to increase your limits. Think about it this way -- if you owe $2,000 on a credit card with a $4,000 limit, you’re using 50% of your available credit. On the other hand, if your limit is increased to $8,000, your utilization drops to 25%, even though your debt remains exactly the same. This can have an immediate and significant impact on your FICO® Score.

  • Use a personal loan to consolidate your credit card balances. Not only does this strategy pay off your credit cards and bring their utilization to 0% on those accounts, but installment debt is considered more favorably than revolving debt like credit cards for scoring purposes. It’s not uncommon for consumers with significant credit card debt to consolidate it with a personal loan and see their score jump by 30-40 points or more.

  • Spread out your credit card balances. Having credit cards that are close to maxed-out can be a big negative factor. For example, let’s say that you have five credit cards, each with a $5,000 limit. We’ll also say that you only use one card, and it has a balance of $4,000. Although you’re only using 16% of your overall $25,000 available credit, that one card has an alarmingly high 80% credit utilization. Spreading your balances out could help in situations like this.

The bottom line on debts and credit

The “amounts owed” category that makes up 30% of your FICO® Score may sound simple enough, but there’s a lot more to it than you might think. By knowing how it really works, and using this knowledge to your benefit, you can make a meaningful impact on your debts’ impact on your FICO® Score, even without paying off a cent.

The Motley Fool owns and recommends MasterCard and Visa, and recommends American Express. We’re firm believers in the Golden Rule. If we wouldn’t recommend an offer to a close family member, we wouldn’t recommend it on The Ascent either. Our number one goal is helping people find the best offers to improve their finances. That is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.