In the world of credit scoring, credit utilization is one of the most important factors. In fact, this factor is second only to payment history in importance to your FICO score weighing in at 30% of your FICO score and it also is considered “highly influential” to your VantageScore.
It’s critical to keep your credit utilization ratio low, but how low is often a mystery to consumers. Let’s dive into this key scoring factor and discuss how it affects your credit.
What is a good credit utilization ratio?
Many experts will tell you to stay below 30 percent, but I suggest keeping it below 25 percent. That’s because once you hit 30%, your score is going to be more severely affected. Keeping that 5 percent in reserve will help to keep from ever getting to the point of affecting your score in a negative way.
One important thing to know is that for those with excellent credit scores, their utilization rates hover in the single digits. That is one big reason why they have those scores!
It is also important to realize that in credit scoring, this measure is one of many that are used in the scoring algorithm in a complex interplay of factors. Just having a higher utilization rate may not have the same impact on one person’s score as it may on another’s.
Utilization is only one part of the credit scoring matrix—your payment history is most important to your FICO score at 35 percent. There is also your credit mix (10 percent), your credit history (15 percent) and new credit (10 percent) to consider.
Also, credit utilizations can vary widely from month to month. Remember that the score you get today can be different tomorrow, based on what has hit your credit report in the meantime. If you make a large purchase but pay it off fairly quickly, your utilization will go down once that payment hits your credit report.
What is credit utilization?
This scoring factor looks at how much you owe compared to your total credit limit. If you divide the amount you owe on a credit card by its credit limit you will get your utilization rate.
For example, spending $500 on a credit card with a $5,000 credit limit equals 10% utilization rate (500 divided by 5000 equals 0.10, or 10 percent). This is the percentage of the credit used of the total amount of credit offered by your credit card company.
This category focuses almost entirely on the balances of your credit cards compared to your credit limit, or your balance-to-limit ratio. The lower your utilization rate, the better your scores will be. Ideally, you should pay your balances in full each month. Leaving a balance doesn’t help your scores. It just means you’ll have to pay interest on what’s left, which costs you money.
To a much lesser degree, this category includes the total amount you owe on all your debts from all sources, including the amount you owe by account type (such as revolving or installment, which for FICO includes mortgage debt) and the number of accounts on which you’re carrying a balance. An important thing to remember about utilization is that it is measured in two ways—both individually and collectively. That overall number will also be used to calculate this portion of your score.
For this reason, it is always a good idea to know what your balances are on all of your cards. If you are planning a major purchase, try to use a card with a higher limit to keep your utilization rate lower. (And have a plan for paying that major purchase off as soon as possible, as well!) You may also want to spread a purchase over more than one card for that purpose.
Why is high credit utilization bad?
Credit scoring exists to give lenders an idea of how much risk they are taking by issuing you credit. Specifically, it helps measure your likelihood of defaulting on your next loan in the next two years. If you suddenly go on a spending spree and start charging up your credit cards and increasing your balances, this sends a signal to lenders that you may be in trouble financially. Or at least, you may be headed for financial trouble. This may not be the case, but lenders only have the data available to them to make their decisions. Be sure that your data is accurate before you attempt to secure additional funding.
How can I improve my credit utilization ratio?
This one is easy—pay down or pay off your bills, of course! Also, once you pay off a card, don’t close it unless you have reason to do so.
It’s a good idea to keep that available credit in your arsenal. You may need to use the card occasionally in order to keep from having it closed, but that is fairly easy to do by using it for purchases you already plan to make (like groceries or gas). You can pay the card off each month this way and keep that available credit to lower your overall ratio. You can also apply for new credit, which will improve your ratio if granted. However, I don’t recommend applying for new credit if you don’t have a need for it.
Now going back to that earlier example, if you are looking to make a large purchase with a credit card, make figuring out how you’ll pay it off part of your overall plan. Paying off a large purchase in 90 days or less is best for a number of reasons – not the least of which is that you will pay less in interest when all is said and done. And paying a large purchase off systematically will be good for your utilization as well your credit history.
Receiving credit is a privilege, and it is a powerful tool. As with any tool, if you don’t use it wisely, you may get hurt. However, a wise use of this tool pays off with higher scores. And the benefits of higher scores can equal better rates for your next big purchase, among other things. So, keep those utilization rates down!