Understanding the Credit to Debt Ratio can help you increase 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.
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 still shows in your Credit Report; but the previous good history you had is not available and therefore can't be used to help calculate your FICO score.
Your credit to debt ratio is reflected in your FICO score. You can calculate your credit to debt ratio like this:
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! Read about what Pat and Jane did:
A few years ago my wife announced to me that we were expecting our first child. Although I was super excited with the news, I automatically went into planning mode.
At that point, we were still living in an apartment and I wanted to welcome my child to a house. We did some research and found that we were a bit under the best credit score mark required to be eligible for the type of loan we wanted.
We decided to work on increasing our credit score. We started evaluating our credit cards and worked towards achieving an ideal credit to debt ratio. This helped us tremendously because although we had credit available, we did really have a lot charged on those credit cards at the moment.
Bumping our credit to debt ratio by reducing a chunk of what we owed on our credit cards really helped increase our score very quickly and allowed us to qualify and purchase a home where we could welcome our first child.
Learn more about your credit:
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; and below 35% (what banks want to see) is even better!
In summary, if you consider the above, you can see why it wouldn't be a good idea to close a paid off account:
What you want to also consider is how you will handle the paid off account. If you can have it and not use it; then do so, providing you aren't paying outrageous annual fees to have the card sitting in your wallet or at home. Marcus used the tips provided to improve his credit score:
Having good credit has always been very important to me, and it became even more important when I decided to apply for a business loan. After checking my credit score, I realized I needed to do everything I could to raise that score.
I had always thought it prudent to close all credit card accounts, but when I learned about the credit to debt ratio, I decided to maintain one of my credit cards.
In doing so, I was able to keep the record of my good history with the credit card company and this gave me a better chance of getting the loan. Ultimately, I was approved and I am very thankful for the knowledge I obtained about the credit to 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. Susan worked hard to reduce her debt which in turn improved her ratio and ratings:
When I began to contemplate the purchase of my own home, I read everything I could and soon learned what lenders wanted to see.
I found that my having three open, active credit accounts in good standing was viewed for payment (history) and balance control (debt ratio). The bank told me anything more than that is frowned upon as a high risk.
They were also glad to see I did not close unused accounts down as they contained a lengthy credit history. I also had a good record of making payments on time or early.
My debt ratio was not, however, within the expected range of 15%-40% (calculated by dividing the limit by the balance). My bank rep said they (Lenders) want to see that you using it, but not too much. If they approved the loan at that time, my interest rate would have been higher as I was too close to the maximum allowed.
I worked on reducing my debt to get my credit to debt ratio in the desired range, all to drive up my FICO score. Sure enough almost two years to the date after I began my return to recovery, I bought a beautiful house without a cosigner or an ugly loan.
If you liked this page - Credit to Debt Ratio, please pay it forward by sharing it on Facebook, Twitter, etc.
This official U.S. Government Web site agrees it may hurt your credit score if you close accounts.