He is enrolled in a credit monitoring program, so he receives alerts when his credit scores fluctuate.
Naturally, I asked him why he thought his credit score could have dropped so dramatically in such a short period of time.
He was quick to explain that he hadn’t paid any bills late, and that nothing negative was being reported on his credit report.
We dug a little deeper and he began to tell me about recent large purchases he had made on several of his credit cards.
It turns out he spent about $15,000 in the matter of a couple weeks, which was nearly 50% of his total aggregate credit line (all credit card limits combined) of roughly $30,000.
Bingo! That was the problem. He essentially used up half of his available credit in a matter of weeks, a big red flag to his creditors and the 3 major credit bureaus.
Think Like the Creditor
Imagine if you knew someone who was going around asking people to borrow money for a new investment.
And that someone had already borrowed $15,000 from five other people.
There’s a good chance you’d be less likely to offer that someone money knowing the person already had $15,000 in outstanding debt.
That’s the same way creditors think, and the reason why credit bureaus depress the credit scores of borrowers with high amounts of outstanding debt.
In fact, 30% of the FICO score algorithm is based on “credit utilization”, which relates to the amount owed on accounts, number of accounts with balances, and proportion of credit limits used.
When my friend went on that spending spree, other potential creditors were given a veritable warning to limit new credit in the form of a much lower credit score, based on the assumption that someone with a greater amount of debt will be less likely to pay back additional debt that is accrued.
25% May Be the Magic Number
The big question is, “How much is too much?” FICO doesn’t reveal everything about their scoring algorithm, but they did note once that those with the highest credit scores tend to keep their “credit utilization ratio” below 25% on their credit cards.
So if you’ve got a $10,000 credit card limit, keeping it below $2,500 may be best, as far as your FICO score is concerned.
As far as VantageScore goes, they say the rule of thumb is to keep balances below 30% of the credit limit on any given account. In our preceding example, that would mean keeping balances below $3,000 on a $10,000 limit.
Clearly my buddy didn’t adhere to either of these rules, and his credit score suffered big time as a result.
And though his credit score was dinged because of his recent spending spree, over time his scores will rise back up as long as he sheds the debt and makes timely payments.
In other words, it’s really just a temporary depression, but one that can cost you a significant amount of money if you apply for new credit or important loans around the time of the drop.
That’s why it’s imperative to avoid large purchases before and during important transactions such as auto leases/loans and mortgage applications.
You won’t want bad timing to hurt you in any way, especially if it means a higher interest rate or an outright declined application.
Keep an eye on your debt and make sure it stays below the key levels mentioned above, and never max out your credit cards! Sure, there will be times when you need to make sizable charges on your cards, but work on knocking those balances down as quickly as possible to ensure your credit scores stay in tip-top shape.
Read more: How to raise your credit score.