Analyze Your Debt to Credit Limit Ratio

By Deepa Venkatraghvan

NEW YORK (MainStreet)--Your credit card is just like the Tree of Knowledge from the Garden of Eden. You can see the unsparing credit line extended to you but really, you cannot use it all. Well, let me put it this way: you can use all of your credit, but if you do, your credit score will take a massive hit. Deceptive, isn't it? If you've been extended a $1,000 credit line, you would assume that you're fine if you stayed within that limit and paid in full each time. The reality is quite different, because there's something called debt-to-credit limit ratio.

Debt to credit limit ratio

"Your debt-to-credit limit ratio is one of the most important measurements in your credit scores," explained John Ulzheimer, president of consumer education at SmartCredit.com. It's easy to calculate: divide the aggregate outstanding balance of all your credit cards by the total credit limit across all the cards.

The ideal ratio?

"According to VantageScore Solutions, the creators of the VantageScore credit score, you are going to want to keep that percentage to below 30%," Ulzheimer said. "According to FICO, the creators of the FICO credit scoring system, consumers with the highest FICO scores have an average debt to limit percentage of 7%. The lower the better regardless of the credit score type."

Now, the important thing to understand here is at what point of time in your credit card cycle this ratio is calculated. "The debt to limit ratio is calculated based on what's reported to the credit bureaus," Ulzheimer said. "And, what's reported to the credit bureaus is your balance based on your most recent statement."

What this means is that if you had a card with a limit of $1,000 and the balance for your statement of May 2013 was $800, your debt to credit limit ratio will get reported at 80%. It does not matter if you paid the balance in full the day after the statement date.

Stay ahead of those credit bureaus

This ratio can be tough on those with lower limits. If you have a low credit line limit of $500, say, it can be frustrating to pay off just to spend another $500. Consumers in such a situation are just trying to earn points and build credit. But in this scenario, to keep the ratio under 30%, it means using only $150 of the limit.