Many factors go into creating a credit score over time, some of which have a bigger impact than others. Your credit utilization ratio is one component of the credit score calculation that is necessary to understand and work to keep in good shape.
Learning what your credit utilization rate is – and why it is vital to your overall financial position – is helpful in maintaining a healthy credit score for the long term.
Breaking Down Credit Utilization Ratio
In the simplest of terms, your credit utilization ratio is the percentage of your available revolving credit card limits you are using at any given time.
Credit card issuers initially provide a credit limit to you when you establish a new account. This limit, also referred to as your spending limit, is the maximum amount you can use on the card. All purchases, balance transfers, cash advances, and fees impact how much of your available credit limit you use.
When you have a balance on a credit card that you do not pay off each month, your credit utilization rate is impacted.
For instance, let’s say you have a credit card with a spending limit of $5,000, and you have a current balance of $2,500. Your credit utilization on that specific card is $2,500 / $5,000, or 50%.
To calculate your total credit utilization ratio, you would need to add up the entirety of your credit card balances and divide that by the total credit limit you have access to among all revolving credit accounts.
How Credit Utilization Impacts Your Credit
A credit utilization rate is one factor that dictates your personal credit score. When your credit utilization rate is high, your credit scores with all three credit reporting agencies – Equifax, Experian, and Transunion – are lowered.
The idea here is that creditors see high credit limit use as a negative, indicating you may be a higher risk of default than someone who has a lower credit utilization rate. This can be a little unnerving, especially since some credit card issuers offer high credit limits, but keeping track of this number is crucial to your credit score.
Most experts suggest that a credit utilization rate should be no more than 30% of your available credit limit. Keeping your credit use below this mark gives creditors peace of mind that you are responsibly handling the spending limits given to you. If you have significant balances on credit cards, however, you are not out of luck.
Here are a few ways to improve your credit utilization ratio to ultimately boost your credit score.
Tips for Improving Your Credit Utilization Rate
If your credit utilization rate is higher than you’d like, the first step you should take is evaluating how to pay down your revolving account balances. Reducing what you owe on your credit card accounts not only brings down your credit utilization percentage compared to your credit limit, but it also helps decrease interest charges that accrue on outstanding balances.
In addition to paying down your credit cards, you can request credit line increases from your credit card issuers. In most cases, so long as your repayment history is good, a credit line increase is an easy process. You simply make the request online or over the phone and provide basic information like your current income and housing payment amount.
It is important to note that most credit card issuers do perform a hard inquiry on your credit report when a credit line increase is requested. This can bring down your credit score by a few points, so be prepared for that change.
Finally, consolidating credit card debt into a personal loan or a home equity loan may prove beneficial in reducing your credit utilization ratio. The process of consolidation involves taking out a new loan and using those proceeds to pay off credit card or other account balances.
Debt consolidation has other benefits as well, including creating a more streamlined repayment plan with fixed monthly payments and the potential to reduce the total interest paid on outstanding debts. Taking out a new loan will likely impact your credit score, however, as you have a new debt on the books.
In Closing
Understanding your credit utilization ratio is a necessary part of working toward a strong credit score over time. Once you learn how credit utilization is calculated, use the tips we’ve mentioned to bring down your rate in a way that makes the most financial sense for you.
