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Understanding Credit Utilization Ratio
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Several factors go into determining your credit score, but one of the biggest components comes down to how much debt you owe and how much credit lenders have extended to you, otherwise known as your credit utilization ratio or rate. This ratio accounts for a whopping 30% of your credit score, according to FICO®.
What is credit utilization ratio?
Your credit utilization ratio looks at your current debt in relation to your credit limits, showing lenders exactly how much of your available credit you’re actually using, and is typically depicted as a percentage.
Max out your credit cards, and you’ll drag your credit utilization ratio up and your overall credit score down — but tap only a small portion of your credit limit, and your utilization ratio will drop as your credit score rises. That’s because lenders prefer a low credit utilization ratio: They see it as a sign you can manage your repayments responsibly, while a higher ratio can act as a red flag warning that you’re a potentially risky borrower.
Anytime you want to take out new financing (like a new credit card, auto loan or mortgage), your credit utilization ratio will impact your odds of getting approved and the favorability of the interest rates, terms and conditions you’re offered because of how heavily it weighs on your overall credit score.
Credit utilization ratio falls under the amounts owed category of the FICO® Score model, which accounts for nearly one-third (30%) of your score. It’s the second most important category, after payment history, and it considers the amount owed and the overall utilization of all your revolving credit accounts, such as credit cards or lines of credit. Installment loans, like your mortgage or auto loan, however, do not factor in this ratio.
How is it calculated?
To figure out how your credit utilization ratio stands up, you’ll need to know the total debt owed and the credit limit of each of your credit cards or lines of credit. With these two figures in hand for each account, the actual number crunching is fairly simple: All you need to do is divide what you currently owe by your credit limit. The resulting percentage is your credit utilization ratio.
Because credit scoring models consider your overall credit ratio, or the amount of debt across all accounts compared to the total credit available across all accounts, as well as the per-card credit utilization ratio, you’ll need to do this same calculation across each of your cards to get a full picture of how each individual account may be helping or hurting you.
“Your utilization rate on individual cards matters because it speaks to how well you manage cards,” according to Matt Schulz, LendingTree’s chief credit analyst. “It’s unclear whether per-card utilization or overall utilization matters more to your credit score. What’s most important to understand is that if you want a really good credit score, you should be aware of both.”
For instance, let’s assume your revolving debt looks this:
| Credit limit | Amount owed | Credit utilization ratio | |
|---|---|---|---|
| Credit card #1 | $10,000 | $5,000 | 50% |
| Credit card #2 | $7,000 | $2,000 | 29% |
| Home equity line of credit | $20,000 | $7,000 | 35% |
| Total of all credit lines and amounts owed and overall utilization ratio | $37,000 | $14,00 | 38% |
These credit utilization ratios already run on the higher side and together can still leave you away from where you’d ideally like to be.
What is a good utilization ratio?
A low utilization ratio is best, which is why Schulz recommends keeping it below 30%: “That’s about as high as you want it to go before it starts really affecting your credit score.” This means that if you routinely use a credit card that has a $1,000 limit, the ideal situation is to charge no more than $300 per month, then pay it off in full at the end of each billing cycle.
“The general rule of thumb is that you want to keep your utilization below 30%. However, the truth is that the lower you can keep your rate, the better,” said Schulz. “Rather than focusing on keeping your rate below an arbitrary threshold, work on making it lower than it was last month. As long as you’re doing that, you’re heading in the right direction.”
He also added that while 30% may be a good target, the real aim should be paying off all balances in full each month.
“A 0% utilization rate should be every cardholder’s goal because it means that you’re paying your balances off in full every month, says Schulz. “Carrying a balance to help your credit score will just cost you money in accrued interest. Are there cases where carrying a small balance might help your score? Maybe. Is the bump to your credit score worth the interest that it would cost you over time? Probably not.”
How does your utilization ratio affect your credit score?
There are several different factors that all work in tandem to determine your overall credit score. Here’s how FICO calculates it:
Payment history — 35%
When it comes to your open accounts, are you diligent about making consistent, on-time payments? It’s by far the most important factor when determining your credit score, as having a negative payment history will come back to bite you.
Amounts owed/utilization — 30%
Your credit utilization ratio is in this category. Again, the general goal is to use no more than 30% of your total credit limit across all your revolving accounts.
Length of credit history — 15%
Those who’ve been actively (and responsibly) using credit for a substantial length of time are likely to have a better score than those who haven’t. Lenders look at the age of your oldest and newest accounts, as well as the average age of all your accounts.
New credit — 10%
Applying for a bunch of new credit cards in a relatively brief time period can ding your score, so apply wisely.
Credit mix — 10%
This may not be the most important piece of the puzzle, but it does still matter. It essentially zeroes in on the diversity of your open accounts—from credit cards to mortgages, and everything else.
How opening another credit card can lower your credit utilization ratio
Because your credit utilization ratio is determined by the amount of available credit you’re using, it makes sense that you can lower that ratio by upping your credit limit or adding a new credit card, but doing so could also lead you into financial trouble.
Pros:
- More available credit, which should help lower your credit utilization ratio relatively quickly—assuming you don’t use that card to fall into a new debt cycle.
- Can consolidate debts onto a balance transfer card, which may lower your credit utilization ratio, reduce your debt payoff timeline and save you money, if you qualify for a 0% interest promotional offer or an interest rate below that of the cards you currently have debt on. You may pay a small fee, typically up to 5% of the transfer, to move existing debts on to the new card and may end up carrying a high balance on the transfer card at first—but once you begin to pay it down, your credit score will reflect that.
Cons:
- Results in a hard inquiry into your credit file, which could ding your credit score by as much as five to 10 percentage points. Be mindful of how often you’re applying for new forms of credit.
- Reduces overall age of accounts. This could hurt your credit score, as the length of your credit history accounts for 15% of it and lenders prefer borrowers with more substantial usage experience.
- More credit means more opportunities to take on debt, potentially raising your credit utilization ratio and leading to higher interest charges.
How to lower your credit utilization
Pay off your debts. “The best way to lower your utilization rate is to pay off your balances. Getting that balance down to $0 should always be a cardholder’s goal,” said Schulz. Remember: The less debt you have, the lower your utilization rate should be.
Increase your total available credit. “Adding available credit can lower your utilization and can be easier than paying down balances,” said Schulz. But you don’t necessarily need to open a new credit card to do this. One handy alternative is to simply reach out to your current credit card companies and request a limit increase on your existing accounts.
“Just remember to not just go out and spend that newly available credit. Otherwise, you’ll just make your financial situation worse,” Schulz added.
While increasing your credit limit can help get the job done, the only downside is that it may result in a hard inquiry on your credit file. Again, a single inquiry is generally no big deal, but multiple inquiries could drag your score down.
Consolidate your debt. Another strategy for reducing your credit utilization ratio is to consider consolidating your debt with a personal loan, or consider using a personal loan to finance a large purchase in lieu of a credit card. Unlike revolving lines of credit, a personal loan is considered an installment loan—in other words, it’s a set amount that you borrow at a fixed rate with a predetermined repayment timeline. Once you receive the money, you can spend it however you wish.
Personal loans are actually a savvy debt consolidation tool if you can find an interest rate that’s lower than what you’re currently paying on your credit cards. In terms of your credit utilization ratio, transferring your debts over to a personal loan can bring it down—so long as you reign in the temptation to charge those cards back up again.
Some things to remember
Your credit utilization ratio is critical to your financial health because it majorly influences your credit score and your chances of getting approved for mortgages, car loans, student loans and credit cards in the future. While you want to aim to use less than 30% of your limit on revolving accounts, the best course is to pay off all balances in full each month, said Schulz.
You can see the impact your credit utilization ratio may be having on your overall credit score by using LendingTree to get a free estimate of your credit score. Sign up here to find out where you stand, learn the major factors that determine your score and determine whether you could save on monthly bills.
If you want to see your credit report in full, AnnualCreditReport.com allows you free access to your reports from Experian, Equifax and TransUnion. You can receive one free credit report from each credit bureau once every 12 months, though you can also access your reports weekly through April 2022.
If your credit utilization ratio is higher than it should be and your credit score is suffering because of it, consider taking out a new credit card, increasing your current limits or consolidating your debts with a personal loan.
Just be sure to research all your options to ensure you’re getting your best terms and rates possible. Or better yet, make a viable plan for eliminating your debt once and for all—it’s the surest way to boost your ratio and credit score.
