If you are like millions of other Americans and plan on charging some of your holiday purchases, you may ask yourself: How much credit card debt is OK to have, and how much will hurt my credit score? Unfortunately, this is a more complicated question than it may seem.
Many consumers believe that by keeping no credit card debt whatsoever they'll maximize their credit score. However, this isn't necessarily true. Here's how your credit card debt affects your credit score, and how much you can have without hurting your credit.
How credit card debt matters to your score
The vast majority of lenders use the FICO credit scoring when making decisions. While the actual FICO formula is a well-kept secret, the FICO people do provide some helpful guidelines for consumers looking to maintain the highest scores possible.
The FICO formula takes into account information from five categories. The most important one that directly has to do with your credit card debt is "amounts owed," which makes up 30% of your score. However, the actual dollar amount of your debt has little importance.
Instead, the most important thing is how high your credit card debt is relative to your total credit limit. For example, if your credit cards' limits add up to $3,000 and you carry credit card balances of $1,500, you are using 50% of your available credit. If you have $10,000 worth of available credit and have $2,500 in outstanding balances, you are only using 25% of the credit available to you, which is more favorable to your score, even though the dollar amount of debt is higher.
In general, the lower the percentage, the better it looks for your score. However, having no credit debt at all could actually hurt some parts of your credit score.
Having no credit card debt might actually do more harm than good
Now, I'm definitely not advocating taking on lots of credit card debt if you don't need to. Credit card interest can be very expensive, and can be rather counterproductive to your financial goals.
Even so, for credit scoring purposes, you may be better off using some of your available credit, even if you charge something small (like dinner at a restaurant) and pay it off over a few months. According to myFICO.com, "[H]aving a low credit utilization ratio can be better than having a high one, or none at all."
The main point of credit scoring is to show lenders how well you handle debt. Can you handle credit responsibly or do you tend to get in over your head?
Well, if you never carry any balance at all on your credit cards, lenders really have no idea if you can handle being in debt responsibly. The largest part of your credit score is actually your payment history, which makes up 35% of your score (more than the amounts you owe), and as long as you make payments on whatever debts you do have, this part of your score should be OK.
However, the FICO website does state that having a small balance and never missing a payment may be slightly better than having no balance at all on your credit card accounts.
The types of credit you use make up another 10% of the formula. Basically, lenders want to know that you use a variety of credit types, including credit cards.
People who never use their credit cards can be viewed as a higher risk by creditors. Lenders simply have no way of knowing how the borrower would handle credit card debt if they had to use it.
The "sweet spot" of credit usage
According to myFICO.com, the average "high achiever" (consumers with FICO scores of 800 or above) uses 7% of their available credit.
A low level of credit usage like this is an excellent compromise between not using so much credit that your debt is uncomfortably high, while still demonstrating to creditors that you actually use your credit and do so responsibly. So for our purposes, we can consider a single-digit percentage like this to be an "ideal" level of credit usage.
Most experts agree that in order to not cause damage to your credit score, the maximum percentage of your available credit that you should be using is 30%. Above that point, it begins to show lenders that you may be having a tough time managing your debts and are becoming too reliant on credit for your living expenses.
So, while the optimal level of credit card debt is a very low percentage of your available credit, as long as you keep it under 30% of your total credit limit, you shouldn't worry too much about your credit score suffering.
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