We talk a lot about credit card balance to limit ratios and there are some basics that need to be established when talking about this particular part of the score.
In this part of the score, they are measuring what percent of your revolving credit is being used. As an example, if you have one credit card and the balance is $500 and the limit is $1000 you are using 50% of your limit. As a rule of thumb, it is best (if possible) to keep your balance under 10% of the limit to maximize this part of your score. Each 10% higher you are, you are potentially earning less points.
The math is easy when you just have one card but can get more complex with each additional card you have. If you have multiple cards then the score would be adding all of the balances together to get a total cumulative balance. The same would happen with the limits. So, in doing this if you had three balances and all of them were $500 each your total balances would total $1500. If each of those cards had a $5,000 limit, that would put your total limits at $15,000 ($5,000 x 3). This would mean your total balance to limit ratio would be 10%.
All of that is usually straight forward but one of the areas that can be a little confusing is if you have a credit card that has a balance (still in good standing) but is closed by the consumer or the creditor. Then what happens?
With a closed card as long as there is a balance the limit is still added into your pool of limits.
- Card #1 (is open) balance is $500 and limit is $600
- Card #2 (is closed) balance is $300 and limit is $3000
- Total balance= $800 and Total limits = $3,600
- The balance to limit ratio as a total is 22%
A lot of people, when paying off credit cards, start by paying off the smallest balance first (often referred to as the snowball method). In the scenario above if that is done, we would go from a 22% utilization and once we pay off the balance of card #2 ($300) the balance to limit ratio would increase. Sadly, in this scenario a person paid off debt and made their credit worse!
Here is why:
The utilization was at 22%, but when the balance on card #2 (a closed card) was paid off and the balance was $0, the limit of that card is now no longer part of the total limits. So rather than having total limits of $3600 instead they only have limits of $600 and their balance on that one card is still $500 which is an 83% utilization. They paid off $300 in debt and made their score worse by doing so. Probably a lot worse!
In a situation like this, better advice would have been to not pay off the closed card until the open card is paid way down or off, then go ahead and pay off the closed card. This way when the card that was closed is removed from your pool of limits it will not adversely affect your credit.
Always remember each action can affect many parts of your credit score, so be careful with what you do!