Editor's note: This article originally ran on WisePiggy.com. It has been reprinted here with permission.
It's a truism: credit scores are important. Have a bad one, and it can make your life miserable, increasing the amount you have to pay for mortgages and other loans, excluding you from great financial deals, including the best credit cards, and affecting a whole range of other essentials from your car insurance rates to your ability to rent an apartment. Worse, some employers access credit files before they hire or promote staff, so the boost to your earning power that could help you get back on your financial feet could be denied you. Monitoring your credit score, and doing all you can to improve it, are very smart moves.
Can lower credit limits improve your score? With so much riding on them, you'd think all the rules for how to improve credit scores would be transparent. But only some of them are. We know, for example, that 35 percent of your FICO score depends on your paying bills punctually. But FICO, which claims its algorithms are used in more than 90 percent of lending decisions in this country, is secretive about many of the details of how calculations are made.
We do know, however, that credit utilization ratios play an important part in determining your score. These ratios compare your total credit card limits with your actual balances. As a rule, the closer your balances are to those limits, the worse the impact on your score. FICO doesn't publish the level that it regards as healthy, but many experts reckon you won't be damaging your creditworthiness if you keep your total balances below 30 percent of your total limits.
Practicalities Let's look at an example: You currently have two credit cards, each with a limit of $8,000, giving you a $16,000 combined limit. Your balances across the two cards total $8,000. That means your credit utilization ratio (CUR) is 50 percent, and you could be damaging your score. The last thing you want to do at this point is ask your card issuers to reduce your limits, because you'd actually be driving your CUR up -- and your credit score down. Instead, you should ideally pay down your card debt at least so it hits that magic 30 percent. Alternatively, you could consider applying for another card -- so increasing your limits and making your balances a smaller proportion of them -- though it's generally unwise to do that if you're planning to make an important loan application anytime soon.
Suppose your credit utilization ratio is in the 0-25 percent range. Would reducing your limits help then? Well, there's no reason to think it would improve your score, but some believe it may help in other ways, providing you keep your CUR at or below 30 percent. Some lenders look at your wider finances when they come to decide on a big loan, such as a mortgage. They could regard exceptionally high limits as a red flag, even if you're not using them, and increase the interest rate they offer you. After all, why do you have those unusually high limits if, in the back of your mind, you're not thinking that one day you may use them?
When lower limits always help If you're one of those people who've never had a credit card they didn't max out, then low limits are your friend. They may not do much for your CUR, but that's going to be shot whatever happens, and at least you should owe less overall. In a perfect world, you should probably avoid credit cards altogether, but it's hard to maximize your credit score without one.
If you really must have one, try using it very occasionally to make sure the account isn't closed by the issuer. Maybe cut it up when it arrives, and use it just for paying one recurring charge, such as a utility bill. Just make sure your card payments always arrive on time.
Use whichever credit-score improvement strategy works best for you. But do take the process seriously. Earlier this year, The New York Times told the heartbreaking stories of highly qualified people whose job applications had been repeatedly turned down because of bad credit. With luck, you'll never find yourself in that position, but, if you don't nurture your score, you could easily encounter significantly higher interest rates on all your borrowing, and even see your loan applications refused.
Peter Andrew is a freelance writer who specializes in business and financial services.