Why is Your Credit Utilization Ratio So Important?Published on March 17, 2022 by CreditFresh
When it comes to the factors that affect your credit score, you may have some questions. While we may have an idea of what aspects of our financial profile affect our credit score (which we’ll discuss later on), how we end up with a specific number may be less clear.
Why are those the exact numbers of your score?
Your credit utilization may play an important role. Knowing what a credit utilization ratio is or what it does may help you understand your credit score better. More importantly, it helps you recognize the steps you may need to take to improve your score.
Here’s how the credit utilization ratio may impact your score.
What is a Credit Utilization Ratio?
Your credit utilization ratio — or credit utilization rate, as it’s sometimes called — is a simple way of comparing the amount of credit you’re using with your total amount of available credit. It depicts how much of your available credit you’re using and is typically expressed as a percentage.
Your credit utilization ratio is a good indication of how you manage revolving credit like lines of credit and credit cards. A low ratio means you aren’t carrying over large balances month to month.
This can be a good sign in the financial world. It suggests that you may not typically spend too much above your means, and that you keep on top of your payments.
How Do You Calculate Your Credit Utilization Ratio?
Figuring out your credit utilization ratio for a particular credit product is easy. All you have to do is divide your balance owing for that particular account by your total credit limit on that same account.
To see what this looks like in practice, let’s use a line of credit as an example. Imagine you received a line of credit worth $2,500, and so far, you’ve used $1,000 of it.
The calculation would look like this:
$1,000 ÷ $2,500 = 0.40
Just multiply this number by 100 and you can see that the credit utilization ratio is 40 percent.
You can follow this equation for individual accounts, or you can find out the overall ratio for every revolving credit account you have.
For example, if you have one credit card and a personal line of credit totaling $10,000, and you owe $5,000 on them collectively, your overall ratio would be 50 percent.
Do Other Loans Affect Your Credit Utilization Ratio?
No, things like mortgages, student loans, and auto loans (in other words, any installment loan) do not count towards this rate. Your credit utilization ratio only includes revolving credit accounts.
What’s the difference between these two options? Revolving credit may offer more flexibility than certain other types of personal loans.
With installment loans, if you’re approved, you borrow funds all at once. However, revolving credit is open-ended. Generally, you’ll receive a credit limit that you may use as much or as little of as you need. The interest you accrue along with any other applicable fees depend on what you use, rather than your total credit limit.
This is the general rule, but it’s important to note how individual credit cards and lines of credit may differ. Make sure you know how a line of credit from a specific financial institution works before you consider it as an option.
Because you control how much of your credit limit you use and how you repay it – as long as you’re making at least the required minimum payments – revolving credit provides unique insights into your credit behavior.
What is a Good Credit Utilization Ratio?
You already know a low credit utilization rate is preferable, but just how low should you go?
As a general rule, some financial experts recommend aiming for a credit utilization rate that’s no higher than 30 percent.
30 percent or less may indicate you have a good handle on your finances. You aren’t maxing out credit cards, and you’re making at least the minimum payments on revolving accounts. As a result, financial institutions may be less likely to flag you as a risk if they have visibility into your ratio.
Note that 30 percent is the maximum threshold and not the goal. The lower you come under 30 percent, the more likely you may be able to impact your credit.
Lower is generally better. But the truth is, there is no ideal credit utilization ratio that will instantly reverse bad credit. This ratio is just one factor affecting your credit. Credit scoring models weigh your credit utilization ratio against other factors to generate your score.
What is a Credit Score, Anyway?
A credit score is a numerical representation of how well you manage credit, among other things. Your score, along with your credit report, are a record of your performance as a borrower.
Some banks, lenders, and other financial organizations may use it to gauge the risk they might face if they were to lend you money.
A high score may suggest that you’re more likely to pay back a loan or personal line of credit on time without issues. A low score, on the other hand, may indicate that you’ll struggle paying back a loan.
As a result, having a low score may limit your borrowing options. But don’t worry — as you’ll see later, bad credit may not stop you from getting help when you need it.
How is Your Score Calculated?
FICO (short for the Fair Isaac Corporation) is the most popular credit scoring model in the country. Experian, Equifax, and TransUnion use it when generating your credit report.
The FICO model evaluates how you perform in the following five categories:
- Payment history: This category uses your past payment history to show whether you tend to pay your bills on time.
- Amounts owed: This is where your credit utilization rate fits in, but it also notes any outstanding loans you have in order to determine your overall debt.
- Length of credit history: This is how long you’ve had various credit accounts open for. Older accounts may help as they provide greater insights into your payment history.
- Credit mix: This is simply the different types of accounts you have, including any mortgages, student loans, credit cards, and lines of credit.
- New credit: FICO wants to see how often you’re opening new credit accounts, so it keeps track of new credit — including new applications for credit where hard credit inquiries are performed.
FICO weighs each category differently, so some are more impactful to your credit score than others.
How Much Does Credit Utilization Impact Credit Score?
The amount of debt you owe is worth 30 percent of your overall score. It’s second only to payment history, so it’s one of the most important components of your score.
It all depends on how you perform in other categories. A single digit ratio may be one of the reasons why you have a good credit score, but you might not automatically have bad credit if you have a higher ratio.
You may temper a credit utilization rate of 40 percent by having a long history of positive payments on a variety of different debts.
Alternatively, a credit utilization ratio of 20 percent may be not enough to impact your credit if your credit profile is relatively new. Without longstanding accounts and very little payment history to report, this ratio may not affect your score as much as you would hope.
How Do You Improve Your Credit Utilization Ratio?
Chances are, you could stand to knock off a few percentage points from your rate. Whether you’re able to do that depends on a lot of factors, including your ability to pay off debt and your overall debt ratio, to name a few.
However, there is a way that may help you impact your credit utilization rate.
Pay your Balances in Full
Paying your credit card and personal line of credit bills in full and on time is one of the best ways to manage your credit utilization. It reduces how much of your available credit you’re using at any given time.
If something happens that makes it hard to pay these bills on time, focus on meeting the minimum payments.
This is one of the benefits of a revolving line of credit. This minimum is often a small percentage of your full balance or a flat fee. In either case, it may be easier to cover this minimum than the full amount owing.
However, make sure you pay more than the minimum balance when you have the cash to spare. Generally, you’ll want to pay off your outstanding balance in full when you can.
This strategy gives you the best of both worlds: it helps build payment history and lower your credit utilization rate at the same time.
How May an Online Personal Line of Credit Help?
A line of credit acts as a safety net when you face unplanned expenses that threaten your budget. If you need a little help covering an unexpected emergency repair, for example, you may consider using a personal line of credit to cover these costs.
So how might a line of credit help your credit utilization ratio? Well, if your line of credit payments are reported to a credit bureau, you may be able to lower your ratio by paying off your line of credit every month, as long as you keep on top of your other responsibilities as well.
How Long Does it Take to Build Credit History?
When you have low or thin credit, all you may care about is how long it takes to build credit history. Unfortunately, it may be longer than you think.
Building a credit history isn’t a 100-meter sprint that’s over in a few seconds. It’s an ultramarathon that lasts most of your adult life. To get to the finish line with a healthy score intact, you have to make sure you pace yourself. Generally, you’ll want to pay your bills on time and keep your credit utilization low.