Your Credit to Debt Ratio
The relationship between closing credit card accounts and your FICO score.
Understanding the Credit to Debt Ratio can help you improve your credit score. You need to know what happens when closing credit card accounts and how that affects your FICO score as an important part of getting out of debt and improving your credit rating.
Fees
Consider
debt consolidation to pay off those credit cards. One payment, usually
a lot lower than your credit card payments, can help you get back on track.
One of the biggest fallacies I’ve seen perpetrated on the web, at the bank,
etc., is that you should close credit card accounts that you are no longer using
to improve your FICO score. When you close the account, your “history” is gone for that credit card … yes, it will still show up on your Credit Report; but the “good history” will no longer be included in the calculation of your FICO score.
One thing that is very important to your FICO score is called the credit to debt ratio. The credit to debt ratio is calculated as follows:
Debt Used divided by Available Credit = Debt Load
Example:
$2,000 of debt charged to a credit card with a limit of $5,000 $2,000/$5,000 = a debt to credit ratio of 50%
$10,000 of credit card debt with total available limits of $10,000 (means you are maxed out on all your cards!) = $10,000/$10,000=100% debt ratio
Example:
$2,000 of debt charged to a credit card with a limit of $5,000 $2,000/$5,000 = a debt to credit ratio of 50%
$10,000 of credit card debt with total available limits of $10,000 (means you are maxed out on all your cards!) = $10,000/$10,000=100% debt ratio
Banks and other financial institutions place a lot of emphasis on your credit history (obtained from you and your credit report) and on your FICO score. Based on this available information; they can easily calculate what your debt to credit ratio is to see just how close to being in financial trouble you are. The closer you are to being over your head in debt, the higher the interest rate you will pay, if you get the loan at all!
The debt to credit ratio is used in the calculation of your FICO score as well; so the higher your debt load to the available credit you have to draw on, the lower your FICO score can be. If you can keep your debt load (the debt part of the debt/credit ratio) under the 50% mark, the better off you will be in the long run.
In summary, if you consider the above, you can see why it wouldn’t be a good idea to close a paid off account:
- it also closes the good history on the account
- it reduces the available credit and increases the debt ratio
Once you have paid off several accounts, then you can review your financial situation and decide if closing one account would be a good idea; after all, you don’t want a lot of unused credit either as it can impact your ability to borrow for a home or car loan; and it’s harder to keep track of multiple cards/accounts as well.
Read more tips on improving your credit score, tips on getting out of debt, and learning money management skills.
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