There are multiple factors that go into calculating your credit score. You know you need to pay your bills on time. And to avoid paying only the minimum on credit cards. But do you understand credit utilization, and the role it plays? Here’s some important information:
What is credit utilization — and what’s considered “good”?
Credit utilization is how much you owe across all lines of credit you currently hold 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 ratio.
For example, spending $500 on a credit card with a $5,000 credit limit equals a 10 percent utilization rate (500 divided by 5,000 equals 0.10, or 10 percent). This is the percentage of credit used of the total amount of credit offered by your credit card company.
Most expert sources recommend keeping your credit utilization ratio below 30 percent of your available credit limits for the best results. For example, Experian, one of the three major credit bureaus, says the following about utilization:
“While there’s no specific point when your utilization rate goes from good to bad, 30% is the point at which it starts to have a more pronounced negative effect on your credit score.”
However, many individuals with excellent credit scores show utilization in the single digits, or even close to zero. This goes to show having a low utilization is good, but it can fall within any range below 30 percent and still be a boon to your score.
Why is high credit utilization bad?
A high credit utilization typically means you are close to maxing out your credit cards, and that signals a red flag to lenders. FICO lays this point out clearly on its website, saying “if you are using a lot of your available credit, this may indicate you are overextended — and banks can interpret this to mean you are at a higher risk of defaulting.”
On the flip side of that, you can show credit bureaus and lenders you’re responsible with credit by keeping your debt and utilization low. Of course, this is in addition to other steps you can take to improve your credit, like paying all your bills on time and using different types of credit to improve your credit mix. If you’re having trouble paying down your debt, a debt consolidation loan or balance transfer card might help you pay it down.
How can I improve my credit utilization ratio?
The primary way to improve your credit utilization ratio is to pay down your bills on time and as much as possible. While this sounds simple, it’s not always easy, depending on your income and how much debt you’ve accrued on your cards.
Also, once you pay off a card, don’t close it unless you have a good reason to do so. Having a surplus of available credit can help you keep your utilization ratio low, and the card also contributes to your credit history, which makes up 15 percent of your credit score. You may need to use the card occasionally 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 also apply for new credit, which will improve your ratio if granted. However, you shouldn’t apply for a new credit card if you don’t have a need for it, since a hard inquiry will lead to a temporary hit on your credit score.
Learn more about managing your credit utilization here.
Your credit score is always changing. That means there are multiple opportunities to make improvements. Credit utilization is just one of the important factors, but it is also one you really can impact. Now that you understand how, take a look at your credit report and strategize!