This is the story of how a poorly-timed credit card purchase turned into a massive credit score drop. While it does have a (mostly) happy ending, there are some lessons to be learned.
Not long ago, a member of my family found themselves facing surgery for a broken arm. Now, we have medical insurance, but that insurance comes with a hefty deductible – one that meant we were still on the hook for a few thousand dollars in medical bills.
Thanks to our handy-dandy emergency fund, we had the cash to cover the cost. But who is walking into the surgery center with a suitcase full of cash? Nope, if nothing else, this medical drama would have the silver lining of credit card rewards.
Now, the card I chose to use was one that offered me the best rate. What I didn't consider was the fact that this card had a lower limit than others I could have chosen. Why did this matter? Turns out that surgery bill was enough to push my utilization rate up over 50% – and my credit score didn't like that one bit.
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The basics of credit utilization
Here, you might be wondering what a credit utilization ratio even is. Essentially, your credit utilization ratio is the percentage of your available credit you're using on any given card (or all of your cards combined).
For example, if your credit card has a limit of $5,000 and you have a balance of $1,000, your credit utilization ratio is: $1,000 / $5,000 = 0.2 = 20%.
Why is this important? Your FICO® credit score is based on five different factors, including:
- Payment history (35%)
- Amounts owed (30%)
- Length of credit history (15%)
- Credit mix (10%)
- New credit (10%)
That second factor, Amounts Owed, is where your utilization comes into play. Rather than just looking at how much money you owe in general, your credit score actually factors in how much of your available credit you're using – i.e., your utilization ratio.
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Using a large portion of your available credit is seen as a red flag, as it could mean you're spending more than you can repay. While you'll have the most issues if your overall utilization is high across all of your accounts, even having a single card with a high utilization ratio can hurt your credit score. (This is one reason it's a bad idea to max out a credit card.)
How it impacted my credit score
In general, it's considered a good rule of thumb to keep your utilization ratio below 30%, with the ideal rate being below 10%. By going over 50%, I set off that little "Danger, Danger!" robot from, well, every sci-fi movie ever.
The result? My credit score dropped a whopping 25 points.
While that seems like a big drop, it actually wasn't as bad as it could have been. I had a couple important factors in my favor:
- Myoverallutilization was still very low. I have a good amount of available credit across multiple credit cards, and this was the only card with a high balance. If I had multiple credit cards with high utilization, my score would have likely dropped much more.
- My credit score was above 800 before the drop. Even losing 25 points, my credit score was still firmly in the "very good" range. If my score had been lower, the drop could have been more impactful.
- I wasn't applying for any new credit right away. Since I didn't actually need to apply for any new credit products – or otherwise undergo a credit check for anything else – the drop to my score didn't actually affect anything important.
If any of these factors had been different, the 25-point drop could have been significantly more painful.
How I bounced back
Your credit score is a rolling number, meaning it changes all the time – sometimes even daily. Part of that is because of when each lender sends your balance information to the credit bureaus. For example, most credit card issuers will send your latest balance information to the credit bureaus once a month, usually when your statement period ends.
This timing means that, even if you pay off your credit card in full before your bill's due date, you could have a high balance reported to the credit bureaus. However, you typically have a grace period between your statement closing date and your bill's due date to pay your balance without being late or being charged interest.
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And this is what happened to me. The medical bill hit my credit card right before the statement period ended. So, that's the balance that was reported to the credit agencies – and was used to calculate my credit score during that time.
Since we had the money in savings, I was able to pay off that credit card in full well before the due date, avoiding interest fees entirely. And as soon as my credit card issuer sent my updated balance to the credit bureau (which was several weeks later) my credit score completely rebounded.
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As a seasoned financial expert with a deep understanding of credit and personal finance, let me dissect the key concepts embedded in the article about a credit score drop due to a poorly-timed credit card purchase.
Firstly, the narrative revolves around the impact of a medical emergency on personal finances, specifically how a significant medical bill resulted in the utilization of a credit card. The individual faced a dilemma when choosing the credit card for the transaction, not considering the potential consequences of the card's lower limit.
The primary issue highlighted is the spike in the credit utilization ratio, a crucial factor in determining one's FICO® credit score. Credit utilization ratio is the percentage of available credit being used, calculated by dividing the outstanding balance by the credit limit. In the mentioned scenario, the surgery bill pushed the utilization rate above 50%, triggering a negative effect on the credit score.
The article delves into the five factors that contribute to a FICO® credit score:
- Payment history (35%): This factor reflects how consistently payments are made on time.
- Amounts owed (30%): The focus of the article, it considers the credit utilization ratio and overall debt.
- Length of credit history (15%): Considers how long credit accounts have been active.
- Credit mix (10%): Assesses the variety of credit accounts (credit cards, mortgages, etc.).
- New credit (10%): Examines recent applications for credit.
The narrative emphasizes that the Amounts Owed category, where credit utilization plays a role, is pivotal. Maintaining a low utilization ratio (ideally below 30%, with below 10% considered ideal) is recommended for a healthy credit score.
The personal experience shared includes a 25-point drop in the credit score due to the high utilization ratio. However, the impact wasn't as severe as it could have been, thanks to a few mitigating factors. The individual had an overall low utilization ratio across multiple credit cards, a credit score above 800 before the incident, and no immediate need for new credit.
The article also touches on the dynamic nature of credit scores, highlighting that they are subject to frequent changes. In this case, the individual managed to bounce back relatively quickly by paying off the credit card balance before the due date, preventing interest charges. The timing of when credit card issuers report balances to credit bureaus is crucial in this context.
In summary, the article provides valuable insights into the intricacies of credit scores, the importance of credit utilization, and how specific financial decisions can impact one's creditworthiness. The personal anecdote adds a relatable touch to the broader lesson, reinforcing the significance of prudent credit management.
