If you think you owe a lot of money on your credit card, you're not alone. Among U.S. households who have credit card debt, the average balance is somewhere in the ballpark of $16,000. Ouch.
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Of course, racking up credit card debt automatically means losing money to interest charges so clearly it's not the sort of thing you want to do. But interest aside, having too high a balance could negatively impact your credit score by driving up your credit utilization ratio. And that could take a long time to recover from.
How are credit scores calculated?
To appreciate the relationship between credit card balances and credit scores, you'll need to understand how credit scores are calculated in the first place. There are five different factors that go into establishing a credit score, some of which carry more weight than others:
- Payment history (35%), which refers to your ability to pay your bills on time
- Credit utilization ratio (30%), which is the percentage of available credit you're using at a given point in time
- Length of credit history (15%), which is the amount of time you've had your credit accounts open
- New credit accounts (10%), which is the number of accounts you open within a limited time frame
- Credit mix (10%), which speaks to the various types of credit accounts you hold
As you can see, of the above factors, payment and history and credit utilization carry the most weight. But while having a high credit card balance won't necessarily hurt your payment history (especially if you make your minimum payments on time each month), a high balance could send your credit utilization ratio into unfavorable territory.
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What is your credit utilization ratio?
Your credit utilization ratio refers to the percentage of available credit you're using up. For this number to help your credit score, it needs to stay at or below 30%. On the other hand, a higher ratio can hurt your score.
Imagine you have a total line of credit of $10,000, and you're carrying a $3,000 balance. From an interest perspective, that's not great. But in terms of your credit utilization ratio, it's actually not such a problem. That's because you're still keeping that number at 30%, which is what credit bureaus want to see.
Now here's another scenario to look at. Imagine you owe $2,000 on your credit cards, but your total line of credit is just $5,000. In this case, you'd be looking at a credit utilization ratio of 40%, which is problematic.
In other words, when we consider the impact of a credit card balance on a credit score, it's not just a matter of the amount owed. Rather, it's a function of that balance combined with the borrower's total line of credit. Even though you, as a consumer, might prefer to owe $2,000 on your cards than $3,000, in the above examples, owing $3,000 on a $10,000 limit is better than owing $2,000 on a $5,000 limit strictly from a credit score perspective.
Paying off your balance is the best bet
No matter what you consider a "high" credit card balance, the sooner you work on paying it off, the lower your credit utilization ratio is going to drop. And that could be just the thing to boost your credit score. So if, for instance, you're doing well in the other four categories that go into a credit score, and you pay off enough of your balance to bring your credit utilization ratio down from 40% to 30%, you're going to see your score go up. It's that simple.
Of course, it could very well be the case that paying down your balance doesn't do all that much for your credit score. If you have a very high total line of credit -- say, $20,000 -- and you only owe $4,000 on your cards, knocking that balance down to $3,500 may not have as significant an impact on your score. But that doesn't mean you shouldn't work on paying it off. Quite the contrary -- the sooner you do, the less money you'll end up throwing away on interest. And that's reason enough to work on getting out of debt, even if it doesn't actually impact your credit score all that much.
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