If the sagging economy is keeping you up at night, make sure your finances are on firm footing.
What is credit utilization?
Credit utilization refers to the amount of credit you have used compared with how much credit you have been extended by a lender. It also refers to a ratio that lenders use to determine your creditworthiness and is a factor that is used to determine your credit score.
Your credit utilization can be calculated using the total available credit you have, including credit cards, auto and student loans, mortgages, home equity loans, or other debt. Some lenders might look at a scoring model that uses fewer lines of your credit, such as credit cards only.
The higher the percentage of credit you’ve used in relation to your available credit, the lower your credit score can be. The total dollar amount of your credit used is not as important as the total percentage of the credit you’ve used.
For example, Bob might have $7,000 worth of credit card debt, compared with Hank, who has $9,000. Yet, Bob might have a lower credit score because he has used 47 percent of his $15,000 in available credit, while Hank has $22,000 in available credit, making his credit utilization 41 percent.
If you are trying to improve your credit score or pay down credit card debt, don’t close your cards without knowing the effect it will have on your credit score. When you close out credit cards, you lower the amount of credit you have available, and if you have any balances on your cards, you increase your credit utilization percentage — and hurt your credit score.
The lower your credit utilization percentage, the better, with recommended ranges often falling below 25 percent, and many advisers recommending that you use less than 10 percent of your available credit. Using some credit is better than not using any credit, because it shows lenders that you know how to use credit.
Example of credit utilization
If you have four credit cards that give you a total of $20,000 of credit and you’ve made $5,000 worth of charges, your credit utilization is $5,000, or 25 percent of your available credit. If you get another card with $2,000 worth of available credit, your credit utilization ratio changes, even if you don’t make another charge or pay down any of your debt. You now have credit lines totaling $22,000 and have used $5,000, or approximately 23 percent of your available credit. If you close one of your cards that has a $4,000 credit line, you now have $18,000 worth of credit and $5,000 in credit used, for a credit utilization of about 28 percent.