It’s tempting to ignore your credit score, as long as you pay your bills on time and otherwise keep up with your financial obligations. However, credit scores are more important than ever before, and there are numerous reasons why you should track your score closely to avoid nasty surprises down the road.
First of all, in an attempt to offset the high stakes of extending credit in today’s default-ridden economy, lenders have raised the bar in terms of who they’ll lend to and how much they’ll lend. This means that credit scores that would qualify someone for a loan with the best rates three years ago, might no longer be considered sufficient for the best terms today.
Secondly, even if you maintain the exact same financial habits you’ve had for the last ten years, you could still be at risk for unexpected dips in your credit rating, due to changes in a slightly obscure part of the FICO score: the credit utilization ratio.
The credit utilization ratio is an important part of credit scores, making up a full 30 percent of FICO scores. It is basically a measure of much of the total credit available a person uses. This component of FICO scores is affected not just by a person’s actions, but by economic conditions as well, because lenders tend to tighten credit during economic downturns.
This is what has happened over the past year. Credit card issuers have been cutting credit limits and even closing credit card accounts altogether, particularly for credit cards rarely used. According to a recent study, nearly one in four cardholders surveyed had seen an account closed or credit limit reduced in the past few months alone.
Card issuers don’t have to notify cardholders about slashed credit limits, so a rarely used credit card with a $10,000 credit could now have a $1,000 credit limit, without the cardholder realizing it. Unfortunately, the decrease in overall credit could trigger a drop in overall credit score, even if everything else remains the same. Why? Because the lower credit lines will cause the credit utilization score to drop, and since this ratio is such a high percentage of FICO scores, the overall credit score could be affected by changes in this ratio.
For example, take a person with $20,000 in available credit across all his credit cards. A $4,000 balance on his card amounts to a 20 percent credit utilization ratio, well within acceptable limits. However, if the credit limit on one or two of his cards is cut, lowering the overall limit to $8,000, now suddenly the credit utilization ratio is 50 percent. So, even though the amount owed hasn’t changed, his score may drop because of the shift in his utilization ratio. Generally speaking, any credit utilization score above 30 percent will lower FICO scores.
So, just how much could a drop in your credit score affect you? Of course, if you start out with an excellent credit score, the impact may be negligible. However, if you’re in the lower range of good credit scores, it could cost you. To get the best terms on credit cards or loans, you’ll need a credit score of at least 740. Below that, interest rates jumps up for every 20 points the score goes down. In addition to higher interest rates, those with lower scores will also need to provide greater equity when applying for a mortgage or refinancing an existing mortgage. Worse, if your score is below 620, you most likely won’t even qualify for standard Fannie May or Freddie Mac loans.
The higher interest rates garnered by low scores can quickly add up. For example, according to FICO, consumers with scores from 760 to 850 can expect to pay rates in the neighborhood of 4.6% on 30 year $300,000 mortgages. Those with scores in the 660 to 679 range, however, would be charged around 5.23%. Though this difference may not seem so big at first glance, it adds up to a whopping $40,300 over the course of the loan.
So what can you do to protect yourself? If you are already paying your bills on time, the most important next step is to monitor the credit limits on your credit cards and make sure to keep your credit utilization ratio low. Experts advise using less than 30 percent of your total credit line; staying well below that limit is the best strategy to prevent your credit score from taking a hit, should your credit limit unexpectedly be slashed or a credit card account terminated. And even if you account limits stay the same, having a low utilization ratio is one of the best ways to boost your credit score anyway.
