Credit utilization ratio: What is it and how it affects your credit score
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When it comes to personal finance (including getting the best credit cards), your credit score plays a large role. Creditors use it as a barometer for how trustworthy you are as a borrower.
One of the main factors used in determining your score is credit utilization, which is a term not everyone is super familiar with. Today, we’re taking a deeper look at what your credit utilization ratio is and how you can maintain a low ratio to improve your credit score.
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What is credit utilization?
The term “credit utilization ratio” describes the relationship between your balances and your total available credit across revolving accounts (such as credit cards). It’s the percentage of your credit limits that you are using, as reported by the three credit bureaus. Credit utilization is sometimes also known as your “balance-to-limit ratio.”
Related: How to use a credit card responsibly
You can calculate credit utilization with this simple formula:
- Credit Card Balance ÷ Credit Limit = Credit Utilization Ratio
Remember, though, that should include all of your revolving credit accounts. So, if you have four credit cards, you’ll want to add up your balance across all cards and the total credit limit across all cards. For example, you have a combined credit limit of $12,000 across two different cards and your credit report shows an account balance of $6,000 spread across those two cards, 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.
You can also calculate your per-card ratio, but the overall average is generally the more important ratio.
Related: How to improve your credit score
How important is credit utilization?
Credit utilization is one of the more important factors that determine your credit score — depending on which scoring model used, it could make up as much as 30% of your score (such as your FICO score). The only other factor with that much weight is your payment history.
Why does it matter so much? Well, from a creditor’s perspective, it can show whether or not you are doing a good job of managing your credit cards. If you are consistently paying off your balances and not using your full credit limit, that tells creditors like card issuers that you are a low-risk customer. The lower risk you are, the more likely you’ll be approved for a card.
What is a good credit utilization ratio?
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 (and therefore lowering your utilization ratio) is often one of the most effective ways to accomplish that goal.
Generally speaking, you should aim to keep your total credit utilization ratio below 30%. This is another reason why we recommend paying off your balances in full each month. It’s the best way to avoid interest payments, and it helps keep your credit utilization ratio as low as possible.
If your credit card balance is higher than usual following the holidays, the sooner you pay down those balances the better off you’ll be in regards to your credit utilization ratio.
Why canceling a card could hurt your utilization ratio
When you cancel a credit card, you’re potentially hurting your score in two ways. First, you are taking away from your average length of accounts, especially if you’ve had the card for a long time. Second, you’re potentially increasing your credit utilization ratio.
Let’s say you close a credit card with a $0 balance and a $10,000 credit limit, but still have two other credit cards. One card has a $3,000 balance and a $10,000 credit limit. The other has a $2,500 balance and a $8,000 credit limit. If you cancel that card, your aggregate utilization ratio increases from 19.6% to 30.1%. Because of that, your credit scores may drop, even though your credit card debt 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.
If you have no-annual-fee credit cards, it doesn’t hurt to keep them open. But if you have a card you no longer use with an annual fee, you can always request a downgrade from your issuer to a different product that doesn’t charge an annual fee.
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.
Additional reporting by Michelle Black.
Featured image by Orli Friedman / The Points Guy.
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