What’s Your Credit Utilization Ratio and How Does It Affect Your Credit Score?
by Kevin Mercadante, Money Under 30
Maybe you've heard of credit utilization ratio, and maybe you haven't. If you follow your credit score, you should have a general understanding of what it is and why it affects your score.
It's the second most important component of your credit score, having only a slightly smaller impact than your payment history. And given that it makes up such an outsized share of your credit score, changing your credit utilization rate could have an outsized effect on your borrowing power. That's why it's so important to understand it.
What Is Credit Utilization Ratio?
Your credit utilization ratio relates to your credit card usage. It is the amount of money that you owe on all of your credit cards, divided by the sum of all of your credit limits. For example, if you have five credit cards with credit limits totaling $20,000, and you owe $10,000 on them collectively, your credit utilization ratio is 50 percent—that is, $10,000 divided by $20,000.
The credit utilization ratio is applied to the total of all of your credit card debt, and is not specific to any individual credit card. This is an important consideration, because it will not help your credit score if you try to lower your credit utilization on one credit card, by transferring part of the balance to another, so that each has a lower credit utilization.
Credit Utilization and Your Credit Score
Your credit score is calculated by each of the three major credit bureaus, Experian, Equifax and Transunion. Each uses the FICO credit score model, although it will yield different results for each bureau. This happens because not all creditors report to all three bureaus, nor will they necessarily report to them simultaneously. This can produce timing differences that can result in different credit scores.
The FICO credit scoring model uses five credit categories to calculate your credit score. In order of importance, they are:
- Payment History: 35 percent
- Amounts Owed (this is your credit utilization ratio): 30 percent
- Length of Credit History: 15 percent
- New Credit: 10 percent
- Types of Credit in Use: 10 percent
As you can see from this list, your credit utilization ratio makes up a whole 30 percent of your credit score, which isn't much lower than your payment history. For this reason, it's possible to have a fair or even poor credit score, even if you have a good credit payment history. The fact that you owe too much on your credit cards can offset an excellent payment history.
It's important to realize that your credit utilization ratio, as well as all other components that contribute to your credit score, don't follow absolute mathematical certainties. For that reason, paying down a credit card may not have the positive effect that you may think that it should.
Here's why: The impact of your credit utilization ratio will vary depending upon your overall credit mix. For example, if you only have two credit cards, and both are maxed out, your credit utilization ratio will have a bigger negative impact on your credit score than if you have five credit cards, two installment loans, and a mortgage.
Though many sources spend a lot of time explaining how you can manipulate your credit score, the reality is that it is calculated based on a matrix that cannot be altered with any precision using different tactics. The general advice may be on target, but the specifics don't always produce guaranteed results.
How High Is Too High?
Okay, so we know that credit utilization ratio is important. But what's a desirable ratio?
Obviously, the lower your credit utilization ratio is, the more positive the impact will be on your credit score. Conversely, the higher it is, the bigger the negative impact will be.
Generally speaking, the FICO scoring models look favorably on ratios of 30 percent or less. At the opposite end of the spectrum, a credit utilization ratio of 80 or 90 percent or more will have a highly negative impact on your credit score. This is because ratios that high indicate that you are approaching maxed-out status, and this correlates with a high likelihood of default.
That's at least the theory, since the credit bureaus generally provide only vague information about the exact impact of your credit utilization ratio, and virtually everything else in your credit score calculation for that matter. For that reason, the better strategy is to simply work to reduce your credit utilization ratio, rather than looking to target a certain desired level.
How Lenders View Your Credit Utilization Ratio
Different industries and individual lenders have different ways of evaluating your credit. While some may look strictly your overall credit score, others may look more closely at specific components.
Your credit utilization ratio can be one of those components. For example, let's say that you have a credit score of 685, which is generally within a lender's range of acceptable scores. However you have a credit utilization ratio of 77 percent, and that particular lender has a limit of 65 percent. You may be declined for the loan—or the loan amount reduced—-because you exceed the lender's credit utilization ratio limit.
This is not an unusual situation. As an example, though you may have a good credit score overall, if you have a history of making late payments on car loans, an auto lender might assign you a subprime interest rate, or even restrict the terms of the loan.
In general, however, you should assume that a high credit utilization ratio will always be an obstacle. It is used by lenders as a critical predictor of default. According to their reasoning, a high credit utilization ratio indicates either a pattern of excessive credit usage, or that you are getting dangerously close to default since you will soon have no additional credit available.
For this reason, you should be purposeful about keeping a relatively low credit utilization ratio, even apart from the impact that it may have on your credit score.
How to Lower Your Credit Utilization Ratio
What can you do if your credit utilization ratio is hurting your credit score, or if you simply want to bring it down to a more comfortable level?
Pay down and pay off credit cards. This is the most obvious strategy. You don't necessarily have to pay off all your credit card debt, but paying it down substantially can make a major difference. Be careful not to assume that every payment you make will automatically translate into a higher credit score. Paying down $1,000 in plastic probably won't have much of an effect if you have $30,000 in total credit card debt.
Obtain new credit lines. The basic idea is to increase the amount of unused credit that you have available. For example, if you currently have $20,000 in credit limits, but owe $15,000, your credit utilization ratio is an uncomfortably high 75 percent. But if you add a $10,000 credit line, giving you $30,000 in your overall credit limits, your credit utilization ratio will drop to 50 percent ($15,000 divided by $30,000).
Be careful with this strategy, however, since it's not as black and white as it may seem. The bump you receive for the suddenly lower credit utilization ratio can be offset by your new credit line, which is brand-new debt. That can take a major toll on the New Debt component of your credit score calculation, even though it's only 10 percent of your score.
Keep your paid credit lines open. Many consumers, anxious to get out of debt, not only pay off credit cards, but often close them out as well. On an emotional level, this can feel as if you are taking revenge on your credit cards. On a practical level, however, you will also be eliminating an open line of credit. That will immediately raise your credit utilization ratio, and that will cause your credit score to drop.
Isn't it ironic that your credit score can actually fall as a result of eliminating debt? But that's exactly what can happen. It's the exact opposite of adding a new credit line. Let's say that you owe $20,000 on $30,000 in lines of credit. Your credit utilization ratio is 67 percent. You pay off a credit card debt of $5,000 on a card that has a credit limit of $10,000, and cancel the card. But in doing so, you've not just lowered your debt to $15,000, but you've also lowered your available credit to $20,000. Your credit utilization now jumps to 75 percent—$15,000 divided by $20,000.
Far from improving your credit score, your situation just got worse. This is why, while it is perfectly acceptable and desirable to pay off a credit card, you should never terminate the credit line.
Maintaining a low credit utilization ratio is important in keeping a good credit score. But think of it less as a specific strategy, and more as a financial lifestyle!
You should always want to keep your debts to a minimum, and you can make that happen gradually. There's no need to obsess on using your credit utilization ratio to improve your credit score.
Related Topics: Finance