Credit Repair

Understanding Credit Utilization Ratio

When breaking down your credit score, your credit utilization ratio is no small thing. How much you owe makes up a whopping 30% of your score, according to FICO, one of the nation’s leading credit reporting agencies. So what is it, and why is it so important? LendingTree reached out to some experts and took a deep dive into credit utilization ratio.

Here’s a breakdown of everything you need to know.

What is a credit utilization ratio?

How is it calculated?

What is a good credit utilization ratio?

How does your utilization ratio affect your credit score?

Should I open another credit card to lower my utilization ratio?

How to lower your credit utilization

Some things to remember

What is a credit utilization ratio?

Your credit utilization ratio (or rate) looks at your current debt in relation to your credit limits. Put it another way: It highlights how much of your available credit you’re actually using.  (aka your credit cards are maxed out), it can drag down your credit score. On the flip side, reducing it gives your score a boost.

This matters because it directly impacts your ability to take out new financing, like a new credit card, auto loan, mortgage and so on. A solid score is crucial in getting approved, as well as securing the most competitive rates and terms, but a high credit utilization ratio tells lenders that you’re a potentially risky borrower.

“When consumers rack up large credit card balances, that often means they may be overextended and more likely to miss payments, so it’s a red flag,” Tommy Lee, a principal scientist at FICO, told LendingTree.

Credit utilization ratio falls under the Amounts Owed category of the FICO model, which accounts for nearly one-third (30%) of your score. It’s the second most important category, right behind Payment History, and it mostly considers the overall utilization of all your revolving accounts.

How much you owe on installment accounts (think personal loans, your mortgage, student loans, etc.) also comes into the Amounts Owed equation, but Jeff Richardson, a spokesperson for VantageScore Solutions, tells LendingTree that what matters most is your revolving balances — accounts that can be charged up and paid off on a revolving basis, like credit cards or a home equity line of credit, for example.

How is it calculated?

Crunching the numbers to figure out where you stand is pretty simple, but there is one obvious question: Should you focus on per-card credit utilization ratios or your overall ratio?

While both are equally important to your score, Lee says the easiest way to go about it is to add up the balances across all your revolving accounts, then divide that number by the total credit limit.

Let’s assume your revolving debt looks something like this:

Calculating Your Credit Utilization Ratio
Amount owed Credit limit
Credit card #1 $1,000 $5,000
Credit card #2 $500 $1,000
Home Equity Line of Credit $10,000 $20,000
Total $11,500 $26,000
Utilization rate                                                       44%

 

Adding up the balances, we see that you owe a total of $11,500. Let’s take that number and divide it by the total credit limit, which is $26,000 — your credit utilization ratio comes in at just over 44%. That actually runs on the high side.

What makes a utilization rate high or low? We’ll cover that next.

What is a good credit utilization ratio?

Our insiders suggest keeping your credit utilization ratio at or below 30%. This means that if you routinely use a credit card that has a $1,000 limit, the ideal situation is to charge no more than $300 per month, then pay it off in full at the end of each billing cycle.

However, this can get tricky for what Richardson calls “transactors”— people who regularly use rewards cards to cash in on benefits.

“Maxing out your card each month, even if you’re paying off the balance, can impact your credit score because scoring models generally look at the previous month as a financial snapshot,” he said.

Richardson adds that VantageScore’s newest model, however, does use trended data that looks beyond one month back. The takeaway is that those who consistently pay off their balances should be protected. Just in case, if you’ve ramped up your utilization to take advantage of rewards, you might want to cool it a few months before financing something like a house or car. This way, your score will be as high as possible when it comes time to apply.

Remember, a credit utilization ratio that’s above that 30% mark may leave lenders questioning your creditworthiness. That said, if your balances and payment history demonstrate that you have the capacity to handle credit responsibly, you should be in the clear. Think of credit utilization as one significant slice of the bigger credit score pie.

How does your utilization ratio affect your credit score?

There are a few other moving parts at play that all work in tandem to determine your overall credit score. Here’s how FICO calculates it:

Payment history — 35%

When it comes to your open accounts, are you diligent about making consistent, on-time payments? It’s by far the most important factor when determining your credit score as having a negative payment history will come back to bite you.

Amounts owed/Utilization — 30%

Your credit utilization ratio is in this category. Again, the goal is to max out no more than 30% of your total credit limit across all your revolving accounts.

Length of credit history — 15%

Those who’ve been actively (and responsibly) using credit for a substantial length of time are likely to have a better score than those who haven’t. Lenders look at the age of your oldest and newest accounts, as well as the average age of all your accounts.

New credit — 10%

Applying for a bunch of new credit cards in a relatively brief time period can ding your score, so apply wisely.

Credit mix — 10%

This isn’t the most important piece of the puzzle, but it does matter. It essentially zeroes in on the diversity of your open accounts — from credit cards to mortgages to everything else.

Should I open another credit card to lower my utilization ratio?

Your total revolving credit limit is a critical part of the credit utilization equation, so it stands to reason that increasing your available credit ought to bring it down.

Using a new credit card to boost your available spending power could help lower your credit utilization ratio relatively quickly — assuming you don’t use that card to fall into a new debt cycle. According to Richardson, discipline is paramount, otherwise, you’ll be stuck with more debt and a potentially higher credit utilization ratio.

That said, opting for a balance transfer card could check off three important boxes: lowering that ratio, reducing your debt payoff timeline and saving you money by locking you into a 0% promotional offer. For a small fee, generally anywhere from 0% to 5% of the transfer, you can move multiple debts onto this new 0% intro APR card. The recommended strategy is to pay off that balance within the introductory promo period, which typically falls into the 12- to 21-month range.

Just keep in mind that applying for a new credit card can also affect your credit score in different ways.

“There are risks associated with opening a new account because one of the other categories in the FICO score is new credit, which makes up about 10% of the calculation, so there are trade-offs,” said Lee. New credit will also lower the average age of your accounts, which could slightly ding your score.

You’ll also experience the minor ding of a new hard inquiry into your credit file, but Lee adds that for the vast majority of consumers, a single inquiry doesn’t have a substantial impact on your credit.

How to lower your credit utilization

Pay off your debts. The simplest option to lower your utilization rate is to pay off as much of your debt as you can. The more debt you pay off, the lower your utilization rate should be.

Increase your total available credit. To lower your credit utilization ratio, boosting your total credit limit while keeping your balances low is one option… But you don’t necessarily have to open a new credit card to do it. One handy alternative is to simply reach out to your current credit card companies and request a limit increase on your existing accounts.

“It’s easy to fall into the trap of using up that new credit if it’s given to you, but if you stay disciplined, a higher limit could positively impact your score because it should lower your credit utilization ratio,” said Richardson.

While increasing your credit limit can help get the job done, the only downside is that it may result in a hard inquiry on your credit file. Again, a single inquiry is no big deal, but multiple inquiries can indeed drag your score down.

Consolidate your debt. Another strategy for reducing your credit utilization ratio is to consider consolidating your debt with a personal loan, or consider using a personal loan to finance a large purchase in lieu of a credit card. Unlike revolving lines of credit, a personal loan is considered an installment loan. In other words, it’s a set amount that you borrow at a fixed rate with a predetermined repayment timeline. Once you receive the money, you can spend it however you wish. Personal loans are actually a savvy debt consolidation tool if you can find an interest rate that’s lower than what you’re currently paying on your credit cards.

In terms of your credit utilization ratio, transferring your debts over to a personal loan can bring it down — so long as you reign in the temptation to charge those cards back up again. Lee adds that while this strategy should improve your credit utilization ratio, the total amount owed will still be in play. Again, it’s not as vital to your credit score as that almighty debt-to-credit ratio, but it is relevant.

Since your payment history is the biggest factor in determining your credit score, faithfully paying off this kind of debt consolidation loan also suggests to lenders that you’re less burdened by debt.

Some things to remember

A solid credit utilization ratio is critical to your financial health because it majorly influences your credit score. Using less than 30% of your limit on revolving accounts is how it’s done, but if you’ve ventured beyond that, all hope isn’t lost.

Whether you choose to bolster your credit score by taking out a new credit card, increasing your current limits or consolidating your debts with a personal loan, be sure to research all your options to ensure you’re getting the best terms and rates possible. (LendingTree lets you compare both balance transfer cards and personal loans using soft credit pulls, which safeguards your credit score while you shop around.)

The other side of the coin is making a viable plan for eliminating your debt once and for all. If you fall short here, it’s only a matter of time before your balances catch up with you.

“Paying down your debt is the easiest way to improve your credit utilization ratio and FICO score,” said Lee.

 

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