What is Credit Utilization?

One of the least understood factors affecting your credit score is credit utilization. It’s an important factor making up 30% of the credit score. So, what is credit utilization?

While credit utilization may sound confusing, it’s relatively easy to understand. It’s the percentage of the debt you carry based on your credit limits. If your credit balance is high or close to the limit, it will lead lenders to believe that too much of your monthly income is going toward debt payments.

Debt-to-Credit Utilization Ratio

It’s often expressed as a ratio called the debt-to-credit utilization ratio. The ratio measures your credit usage against your available credit. Also known as revolving credit, it’s your credit card usage and how much of your open credit lines you are using.

Your credit utilization ratio is the sum of all your credit card balances divided by the sum of your card limits. For example, if your card balance is $400 and your total available credit is $1,000, you have a 40% credit utilization ratio.

There is no perfect utilization percentage, but the lower the ratio, the better. A ratio of 20% is better than 30%. Paying your card bills in full each month is the best way to keep a low credit utilization ratio.

Generally, a credit utilization ratio of 30% or less is acceptable. Improving this part of your credit score can require some strategic thinking. But, again, at 30% of the credit score calculation, well worth the effort.

Controlling your Credit Utilization Ratio

One way to lower your usage ratio is to increase your credit limit. For example, if your balance on a credit card is $400 on a credit card with a $1,000 limit, your ratio is 40 percent. However, a credit limit of $1500 with a balance of $400 makes the ratio 26.7 percent, which is much better. The lower your card balance, the lower your ratio—and the higher your credit rating.

Keep in mind that, since all your cards are factored into your credit utilization ratio, even the ones you don’t use can help your ratio and score. Additionally, if you pay off a credit card, keep that account open, so the available credit line raises the ratio in your favor. Further, asking for credit limit increases can better your usage percentage.

Why Does Credit Utilization Matter?

Why is this important? Generally, the lower the amount of outstanding debt, the higher the credit score, and vice versa. Remember, credit utilization is 30% of your credit score. If your credit burden is high, lenders will think that much of your monthly income is going toward debt repayments. Consumers who constantly reach or exceed their credit limit are seen as potentially risky.

Credit reporting agencies pay attention to your credit utilization ratio because it indicates how well you have your payments in order. A low utilization ratio suggests that your balance is manageable. A high one means you may have difficulty paying your debts.

Final Thoughts on Credit Usage

An open account with a zero balance can positively affect your credit utilization ratio. There can also be a negative effect on your credit score if you close an account.

So, the bottom line is to keep an eye on your credit utilization ratio. A low one is good for your credit score, and a high one is not so much. Comment below. I would love to hear from you.