Credit utilization ratio refers to the percentage of available credit after what you have already used. It is the amount of remaining balances on all your credit cards divided by the total card limit and expressed as a percentage. Credit utilization ratio is a key factor in the calculation of your credit score. Your score can be lowered when you have a high credit utilization ratio or raised by a lower ratio.
This is because the credit scoring formula used by FICO assumes that people who use up a high percentage of their available credit are potentially riskier than those who don’t use much of their credit. Credit utilization ratio is the second most important factor, after payment history, in the calculation of your credit score.
Do lenders consider credit utilization ratio?
Lenders normally prefer to deal with consumers with a low credit utilization ratio of 35% or less. It is, therefore, a good practice to keep your credit utilization ratio at around 30 to 35% if you want to maintain a good credit score. Remember, higher credit utilization ratio lowers your credit score. It shows that you are likely to spend much of your monthly earnings on paying debts and therefore a potentially at risk of defaulting on payments. Lenders are likely to turn down your loan or credit card applications if you have a high credit utilization ratio.
How does credit utilization ratio influence your credit score?
The effect of credit utilization on your credit score depends on the credit model used in calculating your score. Most banks and card lending companies use the FICO 8 model. There are other scores which look at credit utilization differently. This basically means that credit utilization ratio may have a significant impact on one score or a minimal effect on another.
FICO considers credit utilization as a significant part of your score’s debt burden. Credit utilization accounts for 30% of the final score. It is actually the second most important aspect in your credit score calculation after payment history. In the Vantage 3.0 model of credit score calculation, credit utilization influences just 20% of your credit score.
How is credit utilization calculated?
Credit utilization is a simple ratio expressed as a percentage. Anyone can easily estimate their credit utilization as long as they have information about their credit limits and card balances.
All you need to do is to divide your credit balance by the amount of credit limit provided by your creditor.
The result you’ll get will definitely be a decimal figure, for example 0.4685. To geta percentage simply multiply the figure by 100, in our example this will be 46.85%.
Your credit score calculation relies on the data provided in your credit report which may not be the same as what is shown in your online account balance. This is because you may have used the card to make payments several times since the data was updated on your report. So the credit utilization ratio you’ll get may differ from the actual information used in your credit score calculation but gives you an estimate of your utilization ratio.
Credit scores factor in your credit utilization ratio in two ways. One way is by per-card utilization, also known as line-item utilization, which looks at how much you’ve spent based on each card’s limit. The other way is by overall utilization, also known as aggregate utilization, which considers all the cards you have and their limits.
Good utilization ratio
In an ideal situation, the best utilization ratio would be 0% which means that you haven’t used anything in your available credit. In reality, you’ll use your credit at some point in life and therefore your credit report will not show a zero balance. However, the goal is to aim for a credit utilization of less than 30% to maintain good utilization. This means you’ll be using 30% or less of the total sum of credit available to you. You can do this by ensuring that your balances remain under 30% of your credit limit at all times. Raising your usage above 30% of the limit could have adverse effects on your credit score. For example, if you have a credit card limit of $1,000, strive to maintain your balances at $300 or below.
Lowering a high utilization ratio
It is also possible to lower a high credit utilization ratio. You can do this simply by lowering your credit card balances. When you pay your credit cards as much as you can possibly afford to, you’ll lower your credit utilization a little bit quicker. However, the card issuer will not report your balances immediately but will wait until your billing cycle comes to an end. You may not see an immediate reduction of your utilization ratio but keeping your balances low until the end of the billing cycle will help to improve your credit score. If paying your balances right away is not possible, avoid more credit card purchases to keep your balances as low as possible. With less card expenditure, you’ll eventually lower your high credit utilization ratio.
Tips to improve your credit utilization ratio
If your credit card payments have run out of control, it will help to focus on different ways to improve your credit utilization ratio. Aim at improving your credit score by reducing your total credit utilization. Here are a few more tips to help you achieve this goal:
- Ask for higher credit limits from your card issuer and avoid charging more money from the card. This will help to reduce your credit utilization.
- Pay your bill mid-cycle before the due date. Making payments before due date keeps your balances low at all times, especially when the card issuer reports your balances.
- Have disciplined spending. By keeping your overall spending in-check, you’ll maintain total credit utilization in control. Avoid making purchases that you cannot afford to pay at the end of the month. Credit cards will always allow you to spend more than you can pay at the end of the month forcing you to keep on rolling the balance. This uncontrolled expenditure habit will drive your credit utilization sky-high.
- Monitor your credit card statements constantly to stay updated with your utilization ratio and take necessary measures if things don’t look good. Most card issuers allow you to set up balance alerts via SMS or email.
Credit utilization ratio is one of the key factors that influence your credit score. You need to know how it works and different ways of managing your credit utilization to maintain a good score.