Since the whole idea of credit is based on paying back your debts as agreed, it should be no surprise that your payment history is the No. 1 factor used in calculating your FICO credit score. However, the other components of the FICO score are not well understood by many consumers. Coming in at a close second in the formula is a category called "amounts owed," which, despite the name, really doesn't place too much emphasis on the dollar amounts you owe. Instead, it focuses more on your debt-to-credit ratio, which is the amount you owe relative to your available credit.
What is your debt-to-credit ratio, and why does it matter?
Basically, your debt-to-credit ratio is a measurement of how much you owe your creditors as a percentage of your available credit (credit limits). A low debt-to-credit ratio tells lenders you use your credit responsibly, while a high ratio could be a red flag indicating you might be overextended.
For example, if you have a total credit limit of $10,000 and $2,000 in credit card debt, your debt-to-credit ratio is 20%. Meanwhile, if your friend has $50,000 in available credit and owes $5,000, his or her debt-to-credit ratio is 10%. So, even though your friend has 150% more credit card debt than you do, that person might look better in the eyes of lenders (and the credit scoring model).
It's also important to note that the "amounts owed" category is not limited to just your debt-to-credit ratio. Other components include how many of your accounts have balances, the specific balances on certain accounts, and how much you owe on loan accounts (such as mortgages and car loans) relative to the original balances.
The specific formula used to calculate your FICO score is a well-guarded secret, but maintaining a good debt-to-credit ratio is an effective way to boost this category's contribution to your credit score.
How much is too much?
There is no official rule that tells us what constitutes a "high" debt-to-credit ratio, and the impact of a high debt-to-credit ratio depends on your specific credit situation. In other words, maxing out credit cards can affect your credit score and your friends' credit scores in different ways. Having said that, there are some useful guidelines everyone can follow.
The majority of personal finance writers (myself included) recommend using no more than 30% of your available credit at any given time in order to avoid an adverse affect on your credit score. Additionally, the formula looks at individual accounts as well. So, even if you're only using 15% of your available credit, but have one maxed-out credit card, it could be more of a negative factor than if the balance was spread across several accounts. For that reason, I would expand the usual recommendation to include keeping your debt-to-credit ratio below 30% on all of your individual credit cards.
The lower your debt-to-credit ratio, the better off you'll be -- to a point. FICO "high achievers" -- those consumers with scores above 800 -- use just 7% of their available credit on average. Also, FICO representatives have referred to credit utilization of less than 10% as "great shape." However, the company has also cautioned that something is better than nothing when it comes to credit card debt, at least as far as FICO scoring is concerned. In other words, having a balance of just a few dollars on one credit card to demonstrate how you use your credit responsibly can be better for your score than having no balances at all.
To sum it up, the ideal debt-to-credit ratio seems to be in the 1%-10% range, but anything under 30% is considered to be good use of your available credit.
A low debt-to-credit ratio is an important part of maintaining a strong credit score. While there is no set rule, the basic idea is to keep yours as low as possible. Not only will a low ratio help boost your credit score, but you'll also save lots of money on credit card interest by not carrying high balances. Paying down your credit card debt is a winning situation, and should be a high priority for anyone serious about improving their financial fitness.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.