Credit scores are important, especially when qualifying for a mortgage or getting approved for a loan or credit card. Several factors help determine your credit score, and few play a bigger role than your credit utilization ratio, accounting for 30% of your score.
Let’s take a closer look at credit utilization, hows its calculated, and why it matters.
What Is Credit Utilization?
If you’ve been approved for credit cards or lines of credit, you probably noticed the lender set a credit limit. This is the maximum amount you can borrow at any given time. As you use credit, you create debt that must be repaid. The amount of debt isn’t as important in determining your credit score as the debt amount compared to the overall amount of revolving credit available. Credit utilization is the amount of available credit you use, typically expressed as a percentage.
What does it measure?
Credit utilization measures revolving credit usage. Revolving credit is an open-ended credit account with no end date that is typically unsecured. The amount owed carries over from month to month until the balance is paid off. As long as you haven’t reached your credit limit, you can continue to borrow money.
Installment loans, like mortgages and auto loans, aren’t figured into your credit utilization ratio. These types of accounts are still important to lenders and are typically factored into your debt-to-income ratio instead.
How is it measured?
Calculating your credit utilization ratio isn’t difficult, but you’ll need to collect some information first. To determine your credit utilization ratio, you need to:
- Add up all of your balances on your revolving credit accounts
- Add up the credit limits on all of your revolving credit accounts
- Divide your total credit balance by your total credit limit
- Multiply that number by 100
Let’s say your total credit limit was $10,000 and your total credit balance was $1,000. Using the formula above we can determine your credit utilization ratio
Step 1. Total credit balance: $1,000
Step 2. Total credit limit: $10,000
Step 3. $1,000 divided by $10,000 = 0.1
Step 4. 0.1 x 100 = 10
In this scenario, your credit utilization ratio would be 10%.
Lenders aren’t just interested in the total amount of debt you have or your credit utilization ratio. They may look at other data when determining a borrower’s creditworthiness, including:
- Credit utilization per account
- The number of accounts with balances
- Debt from revolving credit accounts vs. installment loans
- Installment loan balances compared the original loan amount
When you apply for financing, lenders may look at any or all of these factors.
Why Credit Utilization Matters
Your credit utilization informs lenders as to what kind of borrower you are. Having a lower credit utilization ratio looks better when applying for loans or other credit products. It shows you aren’t overextended and are more likely to pay off your financial obligations.
How does it work?
Popular consumer credit scoring models, like FICO and VantageScore, look at five factors when calculating credit scores. Each factor accounts for a percentage of the scoring calculation. The five factors used in FICO credit scoring include:
- Payment history (35%)
- Credit utilization (30%)
- Credit history (15%)
- Credit mix (10%)
- Credit inquiries (10%)
Your payment history is the largest factor in credit scoring, which is why late payments have such a negative impact on your score. Besides payment history, credit utilization is the most important factor that affects your credit score.
Who looks at your credit utilization?
Card issuers report credit card balances to credit bureaus each month. The three major credit bureaus in the U.S. are Experian, Equifax, and TransUnion. The reported data is listed on your credit report. The credit bureaus also use it to determine your credit utilization ratio.
Credit scoring models use information from credit reports to determine your credit score. Your score can vary depending on which credit report is used and the specific credit scoring method.
What is a good credit utilization ratio?
According to the Consumer Financial Protection Bureau (CFPB), you should aim to keep your credit utilization ratio under 30%. Keeping your credit utilization lower shows lenders that you are a responsible borrower and less of a lending risk.
How You Can Improve Your Credit Utilization Ratio
Lowering your credit utilization ratio is an easy way to boost your credit score. Here are some simple ways that you can improve your credit utilization ratio.
Pay off card balances
Perhaps the best way to improve your credit utilization is to pay down debt. If possible, make more than your minimum payments to reduce your card balances more quickly.
Keep your accounts open
You might be tempted to cut up your card and close the account once it’s paid off, but this will lower your available credit, causing your credit utilization to increase. If the card carries no annual fee, you may be better off socking it away for safekeeping.
Consolidate your debt
If you have credit cards with high interest rates, you can potentially save money by consolidating your debt through a debt consolidation loan or a balance transfer credit card.
Many balance transfer cards come with introductory 0% APR offers for 12 months or longer. You can move over existing card balances and pay them off over time without paying interest charges. Keep in mind most of these cards come with balance transfer fees. Weigh the interest cost versus balance transfer fees to see if it’s worth moving over a balance.
Request a credit line increase
A simple way to lower your credit utilization is to increase the amount of available credit. Some card issuers allow you to request an increase online, while others may require a phone call to customer service.
Open a new card
Another way to increase your available credit limit is to apply for a new credit card. Keep in mind this could temporarily drop your credit score a few points. Credit card issuers perform a hard credit inquiry with each application to determine an applicant’s creditworthiness.
Your credit utilization ratio is a major factor in your credit score, so do your best to keep your credit utilization as low as possible. You can use a credit utilization calculator or credit monitoring app to determine your credit utilization rate, or you can do the math by hand.
Reducing and keeping your credit utilization ratio low will help boost your credit score and improve your approval odds when applying for loans and other credit products.
