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Understanding Your Credit Score
In order to understand why it is a bad choice to reduce credit card limits or close credit card accounts in order to raise a credit score, it is important to first understand how the credit score works. A credit score is based on data collected by three major credit bureaus- Equifax, Experian and TransUnion. These companies collect data from all of your accounts, opened and closed, keeping a record of payment history and spending.
This data is used by lenders to determine whether a person is a risky lender or whether he or she is responsible and likely to pay back debts. Credit data is used to compute the credit score. Although the exact formulas used to compute credit scores are not published, in general, a credit score is influenced by five factors which are each given a percentage of weight toward their affect on the overall score. These five factors include payment history, debt to credit ratio, age of the accounts, types of credit and new credit opened. To find these percentages, please refer to the first article in this series, below.
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Why Lowering Your Credit Limit Will Hurt Your Credit
Reducing credit limits in an attempt to increase credit scores is a poor idea and will actually backfire, because it will adversely affect the debt to credit ratio. The debt to credit ratio refers to how much available credit a person has. For example, if you have a $100 limit and have charged $50, then you have a 50 percent debt to credit ratio. If you have a $100 limit and have charged $100, then you have a 100 percent debt to credit ratio.
Using more of the available credit a person has received suggests to lenders that the person may be running up large debts or living beyond his or her means. This can decrease the credit score. Most experts recommend keeping credit usage to about 30 percent of the available credit. So, for example, if you have a $100 credit limit, then you should only charge $30 on that card. Staying within the 30% recommendation of usage may increase your credit scores.
Voluntarily lowering the credit limit, especially if a person carries a balance on the card, can make it appear that he or she is using more of the available credit. If before you had a $100 limit and charged $30, the ratio was right in line with what lenders would want and consider favorable. However, if you now have a $50 limit because you reduced your line of credit, the debt to credit ratio is much less favorable. As a result, the credit score will suffer as it looks like you are spending to excess, even if it was your decision to have the credit limit lowered.
Even if you don't carry a balance, lowering the credit limits may hurt the credit score because it may appear that other lenders haven't extended a large line of credit to you. A large line of credit with little or no balance is ideal, as it gives you a favorable debt to credit ratio and it makes it appear to lenders as if others have already judged you to be a good credit risk.
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For additional information, please see the following resource:
- What Does Your Credit Score Say About You