I think I’ve written about utilization, the relationship between the balances and credit limits on credit cards expressed as a percentage, for as long as I’ve owned a computer. But this topic has legs as everlasting as the Gobstopper which shares the adjective. So, for the first time in 2010 and what has to be the 100th time overall, here’s how utilization is calculated.

First off, utilization 101…Mark has a credit card with a $1,000 credit limit. That is, his credit reports show a $1,000 credit limit. His current balance as reported on his credit reports is $500. The utilization of that card is 50% because the balance ($500) divided by the credit limit ($1,000) equals .50 or 50%. Now we can get started.

It’s important to note that the figures I use for my next few examples HAVE to be reported on your credit reports to make these math problems accurate. That’s the bottom line. If it’s not on our credit report then all bets are off.

Line Item Utilization – This is the same calculation as described above for Mark but done for every single open credit card or credit card with a balance. So if you have 10 open credit cards, and open in this examples means it’s not closed, then you’ll have 10 different line item measurements. This is important because the number of highly utilized credit cards on your credit report is a consideration in most credit and insurance risk models.

Aggregate Utilization – This is the same calculation as described above for Mark with one huge difference. For this calculation we are going to combine all of the open credit cards on a credit report to do the math. For example, if I have two credit cards and each has a $5,000 balance and a $10,000 credit limit then I have $10,000 in aggregate balances and $20,000 in aggregate credit limits. Divide $10,000 by $20,000 and you again get .50 or 50%. This measurement is important because the higher utilization the percentage the more risky you are to lenders and insurance companies and the less attractive their terms will be.

High Balance in Lieu of Credit Limits – In some cases your credit cards will not have a credit limit reported. (Note: I’m not talking about charge cards. I’m talking about revolving credit cards that are not reporting a credit limit). In those cases most credit scoring models will look for the historical highest balance, which is typically reported by the credit bureaus, and use that figure in lieu of the missing credit limit. So, if I have a credit card with a $10,000 credit limit but it’s not being reported then the credit score will look for my highest balance figure. If it finds, for example, that your highest historical balance was $7,500 then that’s the figure it will use in lieu of the missing $10,000. So, with my same $5,000 balance and a $7,500 “pseudo limit” I appear to be 67% utilized on that card instead of the true 50%. This is a line item measurement and an aggregate measurement, meaning it is the same regardless of which is being calculated. This practice of withholding credit limits got the credit bureaus sued in a class action case several years ago because Capital One was not reporting credit limits. The case was dismissed because, in my opinion, the court simply couldn’t grasp the details of the problem and the breadth of its impact. Shortly after the lawsuit was filed Capital One began reporting credit limits for the first time in their existence. So, some good did come out of the case.

Missing High Balance and Missing Credit Limit – Now this is a tricky one. In some examples a credit card account will be missing the credit limit and the highest balance. Most credit scoring systems will simply ignore the account for the above referenced utilization calculations because, well, you have no limit to include in the math. This can help the consumer’s scores and it can also hurt the consumer’s scores. For example, if you have a very high balance on that particular credit card but no limit or high credit then that balance can’t increase your aggregate utilization because it’s ignored for that math. It can hurt your score in the example where you have a very low balance relative to the credit limit, which isn’t reported because you don’t get any value of the large difference between the balance and the limit, which is called open-to-buy.

Shadow Limits – A shadow limit isn’t a credit card that’s been left under a leafy tree. Instead it’s the unpublished maximum preset spending limit that all credit cards have, even charge cards that are marketed as not having a preset spending limit. That would suggest that you could use your charge card to buy a $100,000 Mercedes, if the dealership took plastic for such a purchase. And while some very wealthy individuals might be given that amount of shopping power, it’s atypical. The shadow limit is not reported to the credit bureaus so the high balance is the next best figure to use when calculating utilization. And if it’s a charge card the newer FICO scores will not count it in utilization at all. There are, however, revolving credit cards that are also marketed as not having a preset spending limit and, thus, a shadow limit.

The moral of this story is simple; you’d like to do business with credit card issuers who do report the credit limit to all three credit bureaus. It give you the ability to strategically use that card so that you never exceed some self applied utilization percentage. For example, if you know your credit card has a credit limit of $10,000 (and it’s being reported to the credit bureaus) and you never want to exceed 10% utilization on that card then you know you can never allow more than $1,000 to be reported to the credit bureaus as a balance.

For consumers, 2009 will always be known as the year of the ‘credit crunch’.  One of the biggest things consumers will remember is how poorly their credit card companies treated them.  Almost everyone received letters in the mail about their credit limits decreasing, interest rates rising, and the like.  Of course, this abusive behavior led to the passage of the Credit Card Responsibility, Accountability and Disclosure Act of 2009, or CARD Act for short.

Here’s a brief summary of what this Act does for cardholders, among others…

• Credit card companies cannot increase interest rates on existing credit card balances unless a customer is at least 60 days late.
• A guaranteed 21 day grace period on payments.
• 45 days advance notice of any interest rate increases.
• Tough rules around issuing credit cards to consumers who are under 21 years old.
• In the event of an interest rate increase, the credit card company must revert to the original rate after the customer makes six months of on-time payments.  Clearer disclosure of account terms before an account is opened.
• Restrictions on over limit fees. If a consumer has not “opted in” to allow a credit card issuer to approve a transaction that puts you in an over limit positions, they have to either decline the transaction or not charge you the over limit fee.
• No additional fees because of the method of payment.
• Billing statements must be mailed 21 days prior to the due date, and companies cannot charge a late fee if a payment is late due to a delay in processing.  Applications of payments above the minimum now have to be applied to the balance with the highest interest rate.
• A credit card company cannot raise interest rates in the first year of a customer relationship, and promotional interest rates must last at least six months.

So what should I do in 2010 in order to position myself in the best place?  You can find yourself almost completely exempt from the credit crunch by doing two things:

1. Getting out of credit card debt, and
2. Increasing your credit scores.

By getting yourself out of credit card debt it allows you to escape the abusive treatment by lenders. Remember, things like interest rate and minimum payment increases only matter if you carry a balance. Getting out of and staying out of credit card debt puts you in a very enviable position.
A second byproduct of getting out of credit card debt is the significant benefit to your credit scores. “Debt” makes up a whopping 30% of the points in your FICO® scores, which places it a close second behind whether or not you have negative information on your credit reports. And as many people have learned the hard way, the minimum score requirements to not only qualify but also qualify at the best interest rates have become more difficult to satisfy.

This means higher FICO scores equals approvals where in the past a higher FICO score meant an approval with the best rates.

On November 29^th, Liz Weston from MSN published the following article on how FICO Score Damage Points are calculated:

http://articles.moneycentral.msn.com/Banking/YourCreditRating/weston-5-ways-to-kill-your-credit-scores.aspx?page=1

Essentially what happened was FICO simulated the impact of a variety of credit behaviors on FICO scores of both 680 and 780.  This is layed out in the below chart: 

Unfortunately, this information is not entirely correct.  It holds true for some cases, but it leaves out some very important points.  What FICO did not disclose and the article does not convey is that four of the five actions listed above will cause your credit file to be scored in a new scorecard!

FICO scores measure your credit file’s potential risk by scoring it using a unique algorithm specifically designed for your file type, called a scorecard. That means if you have a bankruptcy then you’re scored in a bankruptcy scorecard. If your credit file only has one or two accounts then it’s scored in what’s referred to as a thin file scorecard, and so forth and so on.

Point being, all of our credit files are not scored the same way AND not all are scored using the same FICO formula. Four of the five actions above are negative. And, when a clean file suddenly is hit with something negative it will go from essentially a “clean credit file” scorecard to a “derogatory file” scorecard. The result is a completely different measurement for EVERYTHING on your file. So adding a foreclosure or a settlement or a 30-day late payment or a bankruptcy to your credit file doesn’t “cost” it the points you see above. It causes everything on your file to have a new value so the score change can’t be attributed just to the negative item. The score change has to be attributed to the change in scorecards.

Point differences for the exact same action on the exact same FICO score can be anything but exactly the same. John Ulzheimer, one of the creators of the FICO score, re-interviewed FICO’s Public Affairs Director, Craig Watts. He was able to confirm from Watts that the examples in the FICO chart were “hypothetical” and “could vary significantly” from consumer to consumer. You can Ulzheimer’s his full article here.

http://www.credit.com/news/experts/2009-11-29/real-fico-score-damage-point-amounts-clarified.html

In summary, not all credit scores and scorecards are created equally!  Be careful what you read out there!