Credit Improvement: Your Amount of Debt

How is your debt listed and displayed on your
credit reports?

Each account on your credit report has a section that lists your current balance. This balance is generally the amount you owed on the account as of your previous month’s statement. This “staggered balance” practice is common regardless of whether the account is a mortgage, auto loan, credit card or some other type of credit account.

How many different types of debt are there?

There are several different types of debt.They are…

Installment Debt – Installment debt is money owed to a creditor who expects repayment over a fixed period of time made in equal monthly amounts. A mortgage or a car loan is an example of installment debt. You are making the same payment over a fixed schedule of time. An auto loan, for example, might call for 48 equal payments of $300. A home loan might call for the same payment of $1000 every month for 30 years. You are paying these loans off in installments.

On your credit report it is easy to tell if an account is being reported as an installment account. The numeric Current Status rating will be prefaced by an “I.” The “I” stands for installment.

Revolving Debt – Revolving debt is money owed to a creditor who sets your monthly payment based on the current balance. Credit cards or retail store cards are examples of revolving credit. Each month your balance varies based on your shopping activity from the previous month and any unpaid amount rolled over or “revolved.”

As with installment debt, revolving debt is easily identified on your credit report. An “R” prefaces the numeric Current Status rating. The “R” stands for revolving.

Open Debt – Open debt is the least common type of debt to be found on your credit report. “Open” means that each month you run up a balance and pay it in full when you get your bill. Your cell phone is a good example of open debt. The American Express Green Card is another example of open debt. You don’t have a predefined credit limit and you have to pay the balance in full each month.

An “O” prefaces the numeric Current Status rating. The “O” stands for open.

Why does the amount of debt matter?

Again, there is nothing wrong with being in debt as long as it is managed responsibly and it doesn’t get to the point where it can be overwhelming. Your creditors will do their best to ensure that you won’t get overextended. When you apply for a loan or for a credit card they check your credit reports and measure your level of debt. If it’s excessive they will simply decline your application or counter offer with a loan product that’s more in line with your current level of debt. This is how the industry polices itself. While this works some of the time there are many more instances where overly aggressive lenders grant credit with little regard for the consumer’s debt load. The result is a consumer with so much debt that they are literally one paycheck away from not being able to make their minimum payments. They have become a high-risk borrower without having missed a payment. Research has proven this to be a statistical fact time and time again.

Common sense also dictates that a consumer that is heavily in debt is a poor credit risk compared to someone who has a low to moderate amount of debt. Ask yourself this question…would you rather lend $1000 to someone who has borrowed $1000 from everyone on the block or someone who has no debt?

How is debt measured?

Your level of debt is measured a number of ways, each of which has a different impact to your credit scores.

Your Aggregate Debt – Aggregate debt is measured by simply adding up all of the balances as reported on your credit reports. If you have an auto loan, a mortgage and a credit card all with balances then your aggregate debt will be the sum of all those balances.

Your Number of Accounts with a Balance – This is meant to measure the breadth of your debt, not necessarily your total amount of debt. If you are currently using multiple credit cards and also have other installment loans such as auto or mortgage then these will all show up as separate accounts all with balances. So, for example, if you have 3 credit cards, a home loan and a mortgage all with balances then you have 5 accounts with a balance.

Your Revolving Utilization – Revolving utilization is the amount of your revolving credit limits that you are currently making use of. Remember that a revolving account is an account where your monthly payment is based on your balance. The majority of revolving accounts are credit cards or retail store cards of some type. There are some Home Equity accounts that are also considered revolving. Here is how you can determine your revolving utilization…

1. Look at your credit reports and identify all of your revolving accounts. Each of these accounts has a Credit Limit (the most you can spend on that account) and a Current Balance (the amount that you currently owe on that account).
   
2. Add together all the Credit Limits on all of your revolving accounts. We’ll call this your “Total Credit Limit.”
   
3. Add together all of the Current Balances on the same revolving accounts you just used to determine your Total Credit Limit. We’ll call this your “Total Balances.” Total Balances should be less than your Total Credit Limit amount.
   
4. Now divide the Total Balances amount by the Total Credit Limit amount and multiply that number by 100. This will yield Your Revolving Utilization percentage.

Example – If I have 2 credit cards each with a $5,000 Credit Limit then my Total Credit Limit is going to be $10,000. If I have a $2,500 balance on each of those cards then my Total Balances is going to be $5,000. I divide $5,000 by $10,000 and I get .5. Multiply .5 by 100 and you get 50%. My Revolving Utilization is 50%.

Total Balances ÷ Total Credit Limits = Your Revolving Utilization

This is exactly how creditors and credit scoring models determine your revolving utilization. The percentage that you just calculated tells them how much of your available credit you are currently using. You want this number to be as low as possible. Here’s why:

The Impact to Your FICO® Credit Score

The FICO Credit Score is the standard credit scoring model used in today’s lending environment. Each of us has three different FICO scores, one generated from each of our three credit reports. It’s important to become familiar with the impact your amount of debt has on your credit scores.

Thirty percent (30%) of the points that make up your FICO credit scores is based on your amount of debt. This makes Amount of Debt a close second behind your Payment History. The higher your revolving utilization percentage the fewer points you will earn and therefore the lower your scores will be.

How can you ensure earning the maximum points available out of the Amount of Debt category?

Here are some simple steps you can take to ensure earning the most points out of this category…

• Keep your revolving balances as low as possible. The lower your balances the lower your utilization percentage will be.
  
• Try and increase your credit limits. Revolving Utilization is really nothing more than a math problem. If you can’t decrease your balances then you can have the same effect by increasing your credit limits. However, you must have enough self control to not use up the increased credit limit or you’ll make your situation worse.
  
• Do NOT close unused credit card accounts. The most common and, unfortunately, most incorrect advice given to improve your credit scores is to close unused credit card accounts. This does not increase your scores and can wreak havoc on your revolving utilization thus causing your scores to go down.
  
• Don’t let your creditors close your unused credit cards for you. If you have credit cards that you do not use the credit card companies will eventually close them. They are losing money on you each month that you don’t use your card and eventually they’ll have had enough. Use your card once or twice every few months for dinner or some other low dollar item and pay it off once the bill comes.
  
• Don’t worry about paying all your credit cards down to zero. You don’t need to have 0% utilization in order to maximize your credit scores. Most people don’t have the means to simply write a check and pay off all of their credit card balances. For this category it’s not necessary to do so. Endeavor to pay them down so your utilization percentage is as low as possible and you’ll be fine.

Next…the type of accounts in your credit reports and why having the wrong mix can lower your credit scores.

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