How important is my credit utilization ratio?
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Editor’s note: This post has been updated with the latest information on credit scores. It was originally published on July 10, 2016.
The way you manage your credit cards has a big influence on your credit scores. It’s a given that you should always make your payments on time, but a history of on-time payments may not be enough to maintain good scores. You also need to pay attention to a factor known as credit utilization.
What is credit utilization?
The term “credit utilization ratio” describes the relationship between your balaces and the credit limits on your credit cards. It’s the percentage of your credit limits that you are using, as reported to the three credit bureaus. Credit utilization is also known as your “balance-to-limit ratio.”
You can calculate credit utilization with this simple formula:
- Credit Card Balance ÷ Credit Limit = Credit Utilization Ratio
For example, if you have a credit limit of $12,000 and your credit report shows an account balance of $6,000, your credit utilization ratio is 50% ($6,000 ÷ $12,000 = 0.5 X 100 = 50%). In other words, you’re using 50% of the credit limit on your account.
How important is credit utilization?
Credit utilization is one of the more important factors that determine your credit score. Only your payment history is more important. Under FICO scoring models, credit utilization is responsible for almost one-third of your credit score.
Credit scoring models reward you when you keep your credit card utilization rate low. If you’re looking for a way to boost your credit scores, paying down your credit card balances is often one of the most effective ways to accomplish that goal.
Why closing an account can raise credit utilization
Credit utilization is considered twice where credit scores are concerned. First, utilization influences your score on an account-by-account basis. Second, your overall or aggregate utilization rate is considered on all of your credit cards combined.
We covered how individual utilization is calculated above (balance ÷ limit = individual credit utilization ratio). Aggregate utilization is calculated in a similar manner. However, you have to add up the balances on all of your credit cards and the limits on those same accounts first.
You can find your aggregate credit utilization ratio using following formula.
- Total Credit Card Balances ÷ Total Credit Limits = Aggregate Utilization Ratio
Imagine you have three credit cards. Two cards have a balance of $1,000 and one account has a $0 balance. Your total credit card balances would be $2,000.
- Credit Card #1: $1,000 Balance
- Credit Card #2: $1,000 Balance
- Credit Card #3: $0 Balance
- Total Credit Card Balances: $2,000
Each credit card has a $2,000 credit limit. So, your total credit limits would be $6,000.
- Credit Card #1: $2,000 Limit
- Credit Card #2: $2,000 Limit
- Credit Card #3: $2,000 Limit
- Total Credit Limits: $6,000
In the example above, your aggregate utilization ratio would be 33% ($2,000 ÷ $6,000 = 0.33 X 100 = 33%).
Building on this example, let’s assume you close the credit card with a $0 balance. Your aggregate utilization ratio increases to 50% ($2,000 total balances ÷ $4,000 total limits = 0.5 X 100 = 50% aggregate utilization). Because your utilization jumps to 50%, your credit scores may drop, even though your credit card debt ($2,000) is the same amount it was before.
Canceling a card reduces your total credit limit (the denominator in the utilization ratio). For many people, that can result in higher utilization and lower credit scores. Ultimately, whether a credit card closure hurts your credit score largely depends on how many other accounts you have open and how much you use them.
The ideal credit utilization ratio
As a rule of thumb, lower credit utilization ratios are better for your credit scores. FICO reports that its “high achievers” — those with credit scores of 800 and up — have an average total revolving utilization rate of 5% or less. High FICO Score earners in the 750–799 range keep an average utilization rate of 15% and under.
Do you want or need to close a credit card? Ideally, make sure all of your credit card balances are paid off and reporting a $0 balance to the credit bureaus first. As long as you can maintain a utilization rate of less than 15%, you may be able to maintain a good credit score even after you close the account.
However, if closing an account will push your utilization ratio up to 15% or higher, you should consider other options. Downgrading your account to a no-fee version or replacing the old account with a new one first might be a better move. Closing accounts can affect your credit score by increasing your utilization ratio.
If you decide to swap your current accounts for other cards with no annual fee, it’s usually best to apply for the new card before canceling the old one. Your existing credit line will still be factored into your score and your utilization ratio will remain low while your application is being considered.
Of course, new applications also have an impact on your credit score. Be sure to consider the situation from multiple angles before you make a decision.
For more info about when to cancel a credit card, check out these posts:
- My credit card inventory: Which to keep and which to cancel?
- Will my credit score drop if I don’t use my credit cards?
- Should I cancel a credit card if I don’t use it anymore?
- Should I reduce my high credit limit if I don’t use it?