Credit Utilization Ratio: What You Need to Know
If you’re like most consumers today, you probably have an open credit card or two in your wallet. You might also have a few loans to pay off and other revolving debt like student loans, car loans, or mortgages. But still, what is the credit utilization ratio and why is it important for you?
A credit utilization ratio is one of the tools lenders use to assess how much money you owe on these accounts compared to what they are worth. In other words, it’s a measure of how much money you’re using compared to the total credit available to you.
The higher this ratio is compared when it comes to its value, the worse your score will be. This is because it means that you are using a bigger percentage of your available credit than lenders would prefer. There’s more risk involved with borrowing money to these individuals because if something happens to their accounts such as an unexpected bill or late payment, they will not have that much money to cover it all up.
To give you an example to better understand this, say that you have $15,000 in total available credit across all of your accounts (including savings and checking). If you had no debt at all, that would mean you have a 0% utilization rate. In case you then decide to spend half of this money, it would mean that you have around a 50% utilization rate.
What Is a Credit Utilization Ratio?
Credit utilization ratio by definition is the amount of credit you have available compared to the amount of credit you’ve used. It’s one of the factors that determine your credit score and can be used to determine how much more you can access in terms of loans, lines of credit, and other types of financial products.
The most common type of utilization ratio is known as a balance-to-limit ratio. This type simply calculates how much debt you’ve taken on compared to how much available balance there is on your card or loan account. In this case, if your car loan has a $10,000 limit but it has just $2,000 left on it, then that would be considered a really high utilization.
How Does Credit Utilization Work?
The credit card utilization ratio is the amount of money you owe on your credit cards divided by the total amount of credit available. If you have a $1,000 limit on one card and a $10,000 limit on another, your total available credit is $10,000. That means that if you spend $2,500 on each card (for a total balance of $5,000), your utilization rate would be 50%.
Depending on the utilization ratio on your credit card, the lenders will see you as either a good or bad potential borrower. If you have too high of a ratio the lender will see you as someone who has bad financial habits and therefore be hesitant to approve any loan you applied for.
The best credit utilization ratio is below 30% so try to keep it at this mark.
If you want to improve your FICO or VantageScore, keeping track of your expenses and being sure you are in the recommended credit utilization ratio will help immensely.
What Is a Good Credit Utilization Ratio?
As we already mentioned, the best credit utilization ratio is 30% or less. This means that you are not spending more than 30% of your available credit on any given month. While this may sound like way too little money, it makes sense when you consider that lenders will look at the amount of available credit in comparison to how much has been used during that period.
If you have good credit and want to maintain it, this should be one of your goals. If you have bad credit and want to improve it, this should be one of your primary goals! The aim here is not just having a healthy FICO score but also having enough available lines of credit so that if something happens in life where immediate access to money is needed (like an emergency car repair), then there will be no issue getting the funds necessary without having to pay exorbitant interest rates or penalties.
These late payments due to the “overdrawing” of these accounts by using them excessively and incurring high fees because of those overdrafts will add up really fast and cost you quite a bit of money.
How to Calculate Your Credit Utilization Ratio
In short, it’s a way to measure how much debt you’re carrying compared to your total available balance. The higher your ratio, the riskier you might be considered by lenders because it indicates that you are using more of your available credit than others with similar scores and loan balances (so-called “good” debt).
After you got familiar with this whole topic, you may be wondering how do I calculate my credit card utilization ratio? And can I know it without visiting a bank?
Well, the good thing is that calculating this ratio is fairly easy and it goes like this:
Credit Utilization Ratio = Total Balance / Total Credit Limit
Use this measurement you got, to know exactly how much you can spend each month without having to worry that your score will be affected by the spending. Take into account any time limits associated with having too high a ratio or risk of being unable to take out additional loans in the future if necessary.
If you are struggling to use the formula we provided you with, there are many credit utilization ratio calculators available online that are basically the same versions and can also give you a good estimate of your ratio.
How Does the Credit Utilization Ratio Affect Your Credit Score?
The credit utilization rate isn’t the only factor influencing your credit score but it certainly is really important in constricting your total score.
The lower your credit utilization ratio, the better your score will be. We will give you one more example because this whole topic is easier to understand through various examples that are more or less applicable to your own situation.
So, if you have $3,000 worth of balance on a card with a $10,000 limit, then your balance would equal 30% and you’d have an excellent ratio ($30/$100). However, if that same card has no limit at all (or is technically infinite), then there’s nothing stopping you from maxing out its balance at 100%. The resulting 0% would be considered very poor by lenders who use this metric to determine whether or not they want to give someone more money (like during an application process).
Having too high of a utilization ratio on a credit card or some other type of account will be seen as that you are not able to manage your expenses well and that you are often maxing out your cards. This will further lower your score and make you less eligible for many other loans you are maybe planning or even trying to get.
Making these irresponsible financial moves can lower your score by 40 to 50 points in a really short time so be extremely careful.
If you need any help with managing your finances better, we suggest you hire an experienced financial advisor that will be able to take into consideration all the different factors contributing to your expenses.
How Can You Lower Your Credit Utilization Ratio?
By now you probably know that the lower your ratio is- the better your credit score will be as well. But let’s now look at some ways you can achieve this desired goal.
In order to lower your credit utilization ratio, you must reduce the amount of money that is available for use.
Here are some ways to do this:
- Pay down debt. The simplest way to pay down debt as soon as possible is to pay more than the minimum payment required by your credit card issuer. This will help you save money on interest payments, which can be significant over time. Additionally, setting more money aside for this purpose will help you never fall behind on these payments.
- Use a balance transfer card. A balance transfer card allows consumers with high-interest-rate debts on their credit cards to transfer those balances onto another card with a low or zero interest rate for a period of time (usually six months). This can save hundreds or thousands in interest charges over just one year’s time frame if done correctly! Be sure to visit your bank and get as much as possible information about this procedure.
- Close unused accounts and don’t open new ones if possible. Closing unused accounts will lower your overall debt load while also reducing the amount of available credit that could potentially be used up by future purchases, improving your score altogether.
- Request a credit card limit increase. If your current limit is too small it may just be impossible to keep your utilization ratio below 30%. The solution to this may be calling your bank and asking them to put a higher limit on your card so you can have more money for budgeting all the expenses.
- Get a new credit card. If you cannot achieve the perfect ratio with your current card, try getting a new one just to have a bit more funding available.
Final Thoughts
The credit utilization ratio is one of the most important factors in determining your credit score, and a low number can help improve it. If you plan to buy a house or car soon, keep an eye on this number to make sure it remains as low as possible. This will give you plenty of opportunities when applying for a loan.
However, don’t forget that this factor is closely connected to all the others such as payment history, credit mix, credit history, and inquiries and that they altogether determine your credit score and ability to borrow money.
Your credit utilization ratio is contributing about 30% to the overall score. The higher it is, the more likely you are to face negative consequences like higher interest rates on loans or being denied credit cards. Therefore, it’s important to monitor this number and keep track of your progress over time as you work on building up your credit score!
