Debt utilization is a vital part of credit scoring and financial health. Also known as credit utilization, it accounts for 30 percent of your credit score, measuring your total debt compared with total credit limit. For example, suppose you have a credit card with a $10,000 limit and a $5,500 balance. Here’s how your ratio is calculated:
$5,500 balance/$10,000 limit=0.55 x 100 percent = 55% ratio
Consumers with FICO scores of 800 and above maintain utilization ratios of 25 percent or less. Low debt equals low risk and greater potential for credit score improvement.
Credit utilization can be confusing if you aren’t sure which debts are included in the mix (more on that here). A fairly recent source of consumer debt lies in the hands of education lending. Student loans represent $1.23 trillion of the national debt. 43.3 million Americans currently carry student loan balances, and the average 2015 graduate owed at least $35,000. Despite these overwhelming statistics, there are a few pieces of good news:
- Student loans are considered installment debt — loans that are repaid in equal amounts over a determined period of time.
- Credit utilization ratios measure revolving debts like consumer credit cards into order to gage risk
- Student loans do not directly impact credit utilization
While it’s true that education debt is not part of the credit utilization ratio equation, that doesn’t mean they aren’t linked. Regardless of debt type, high balances have the power to damage your credit scores by raising your risk level, a factor that carries costly consequences. Consider the following example:
Elias is a medical student at Indiana University. Although his education has been supported by financial aid and scholarships, Elias’s student loans still exceed $115,000. Upon graduation, Elias is surprised when his first student loan bill arrives. The amount due: $825. Elias decides to rely on credit cards for necessity items in order to pay his student debt. After six months, Elias has amassed $6,000 in credit card debt and raised his utilization ratio to 74 percent. His variable interest rates begin to rise on his credit cards and private student loans, causing his minimum payments to increase and overall debts to rise.
Elias fell into a common trap associated with credit damage: using borrowed funds to make ends meet. Although student loans didn’t impact Elias’s credit utilization directly, his poor management skills caused undeniable harm.
The bottom line: The common thread of credit and financial stability is risk. Manage both by considering how one financial choice could affect your life and future needs. Consider asking a credit repair professional to help you make these tough decisions. Their insight can help you protect your savings and your credit score.