Nowadays credit cards provide the ability to build a credit record and receive a credit score. When you use credit cards responsibly, you have access to additional funds in an emergency.
Credit utilization is the amount of credit that you have already used compared to the total amount of credit that you have available. Take note that this is only based on your revolving credit which is essentially all the lines of credits and credit cards you currently possess. The credit utilization ratio does not include personal loans, auto loans, and even your mortgage. These are factored into the debt-to-income ratio which is not included in the calculation of your credit score.
What is revolving credit, anyway? Well, this is the type of credit that does not have a fixed end date. Instead, the balance (the amount that you owe) carries over from month to month. Each month, you can opt to use more of your available credit, pay some or all the balance, and then borrow against that amount again. If you have not exceeded your credit limit and your account remains in good standing, you can continue to borrow money using your line of credit or credit card. Each month, the amount you borrowed will incur interest unless you pay the balance in full. This helps lower your credit utilization ratio. The lower your credit utilization rate is, the better. So, why is that important? Well, this ratio indicates how well you're keeping your spending in check and how likely you will be able to pay off any new debt.
So, how do you find out what your credit utilization rate is? As we’ve already mentioned, this rate refers to the amount of revolving credit that you have used compared with the total amount of revolving credit you can use. To find out what your credit utilization rate is, follow the step-by-step formula below:
Step 1: Add up all the balances on your credit cards and lines of credit.
Step 2: Add up all the credit limits on all your cards and lines of credit.
Step 3: Divide the total balance by the total credit limit.
Step 4: Multiply the quotient by 100 to get the percentage.
Take note that there are two different credit utilization ratios: per-card and overall. The above formula calculates your overall credit utilization ratio. To get your per-card ratio, just divide the balance by the card’s credit limit. This number tells you how much of each card’s credit limit you are using.
Here’s an example. Let’s say you have a credit limit of $1,000 on one credit card. It has a balance of $250. Based on the formula, your credit utilization for that card is 25%. If you have a second credit card with a limit of $5,000 and $500 worth of charges, your total credit utilization rate changes even if you don’t pay your balance or charge. From 25% with one card, it becomes 12.5% for two cards. The second card has a per-card utilization ratio of 10%.
So, how does this rate affect your credit score? We all know that your credit score is used by lenders to gauge how likely you are to repay any money you borrow. Credit scoring models like FICO and VantageScore use the credit utilization ratio as a factor in calculating an individual's score. With FICO, 30% of your credit score is based on this ratio. In fact, this scoring model uses both per-card and total utilization rates, so getting a high ratio on either category can negatively affect your score. VantageScore, on the other hand, bases 23% of your credit score on credit utilization. That being said, your balances make up 15% of your score and available credit makes up 7% of your score which means that a total of 45% of your credit score will be based on your credit card debt.
So, what does this mean? The higher the credit utilization ratio, the lower your credit score will be. A high balance is more difficult to pay off and could mean that you're overextended. It tells lenders that you're possibly at risk of falling behind on your payments which may mean that they will have difficulty getting their money back. On the other hand, the lower the ratio is, the better off you will be. In fact, financial experts recommend maintaining a credit utilization rate of 30% or less on all credit cards and lines of credit at all times. This is because it signifies to lenders that you don't rely too much on credit, you're financially responsible, and therefore, a much lower risk to them. However, you should also know that it’s better to use some of your credit instead of just letting it stay at zero. This shows lenders that you know how to use credit responsibly.
Take note that the actual dollar amount of your balance is not as important as the percentage of credit that you have used. For example, let’s say that your total balance is $6,000 while your friend Betty has $9,000 total in credit card debt. However, your total available credit is $10,000 which means your credit utilization ratio is 60%. Betty, on the other hand, has a total credit limit of $25,000 which means her ratio is at 36%.
Which credit utilization rate is more important? Actually, both are taken into account when your credit score is calculated. You'll need to keep an eye on both rates if you don't want them negatively affecting your score.
Let's say you have a maxed-out credit card and you want to lower your credit utilization ratio. Opening a new credit card or line of credit and keeping that balance at $0 isn't going to help you much. Yes, it will lower your total credit utilization rate but the high utilization ratio on one card still has the potential of bringing your score down.
Using only 30% or less of your available credit is essential to getting a good credit score. But is it doable? Yes, it is. Below are some tips that can help you maintain a low credit utilization ratio:
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