Having credit—primarily through credit cards—can be a very important aspect of life. Credit cards often give a person the financial history necessary to get bigger loans, like for a car or a first home. Many people believe that having more than one credit card—and thus a bigger line of credit—with debt spread out is an integral factor to building a strong credit score. While this can be true, the way you manage your debt versus credit known, as a “credit utilization ratio,” is a much bigger factor for your credit score.
The credit utilization ratio is an equation that measures how much of your available credit is being used each month. It is your debt divided by your total credit line. If you have charged $4,000 to one card and $1,000 to another and your total credit line over both cards is $10,000 the credit utilization ratio is 50%. In this example, even though the borrower makes regular payments (and maybe even pays off the full balance each month) having 50% of the total credit tied up in debt is way too high, and considered a risky bet by most lenders. So despite the fact that the balance may return to zero each month, the credit utilization that is factored into the credit score only uses the ratio of credit used to credit available.
So how exactly does credit utilization factor into your FICO credit score? The score is an algorithm that uses many different factors. Primarily the five criteria used are:
- Payment history (35%)
- Amounts owed (30%)
- Length of credit history (15%)
- New credit (10%)
- Types of credit used (10%)
The “amounts owed” category comprises of a few different things, but within there is your credit utilization ratio. The lower your credit utilization ratio the better—a good target to shoot for is between 10 and 30 percent.
When trying to manage your credit utilization there are many different approaches you may elect to take. One approach is to open up new lines of credit by applying for more credit cards and spreading out the debt. Indeed, this will lower your credit utilization ratio; however, this is not a fool proof way to raising your score. Remember that your credit score also takes new credit into account. Every time you apply for a new credit card that is factored into your score, and that can hurt your score more than if you didn’t open up new lines of credit. Furthermore, if you are denied for a new line of credit—because your utilization ratio is too high—that can also negatively affect your score. This method also changes your length of credit history, and though it might not have an adverse effect, it’s something to consider.
Sometimes when people are trying to get a handle on their finances they may decide that they possess too many credit cards, and it’s a good idea to cancel one. Besides the effect it has on your credit history, this is also not advisable because of the negative impact on your credit utilization. For example, if you have three cards that total a line of credit of $15,000 and the balance on one is $3,000 and $750 on another and $0 on the third, the current utilization ratio is: 25%. If you were to cancel the third card, which drops the total line of credit to $10,000, the new utilization ratio becomes: 38% (rounded to nearest whole number). Although that may not seem like a significant jump, the ratio has now drifted outside of the 10 to 30 percent sweet spot, making you riskier to lenders and possibly even raising the interest rates you will receive in the future. It would be a much more prudent idea to transfer a portion of your higher balance to your other card and continue making regular payments. By doing this your utilization stays the same, while your payment and credit histories grow positively.
What do you mean by revolving credit?
The credit utilization rates are based solely on revolving credit. That includes your credit cards and line of credit essentially. The rates that are decided are exclusive of the installments loans like a mortgage and various auto loan. These factors take your credit in a way different way. Now, you may be wondering why it is called as revolving credit.
It is called revolving credit because it does not have a predetermined end date. The amount your owe gets carried over from months to months. Every month, you are free to borrow against your credit limit. That reduces the amount of credit that is available. You have the option to repay all of it or borrow against the available amount again!
Remember that as long as your amount is in good standing and you have not reached your set credit limit, you are allowed to borrow amount with your credit card or line of credit. Every month, you are required to pay interest on the amount of credit that you have used. If you are regular in paying your credit balance in full every month, you would not be incurring any interest charges, and your credit utilization ratio will be considerably low!
Next comes the installments loans
Installments loans like the mortgages and auto car loans have been relatively factored and structured with a greater understanding. The vehicle lenders and mortgage companies often use a different parameter for deciding the worth of your financial proceedings. They use your debt-to-income ration to understand how much of your total annual income goes in for paying off the installment debts. On the other hand, you may also find that many lenders use the debt-to-income ratio to make decisions and consider it a valuable indicator. Indeed, this is not used to calculate your credit scores.
What do you understand by per card and total utilization
You must have known that your credit utilization rate is generally a comparison of total credit used to the amount of credit you are using on individual cards. Well, that can be an important aspect! Your pre-card credit utilization rate is well calculated in the same way as your overall utilization rate. The difference is that it compares the balance of an individual credit card to that of the available credit card in the same ratio.
What can be a good credit utilization rate?
It is strongly recommended that you keep your credit utilization rate below 30%. For instance, let us make that simple to understand with an example. If you have got your total credit limit as $10,000, then, in this case, your total revolving balance should not exceed $3000. In general, we can say that a low credit card utilization ratio is considered a strong indicator that you are on the right track for managing your credit responsibilities. In short, it shows that you are far from the habit of overspending. On the other hand, if you have a higher rate, it could be meant to flag to potential lenders or the creditors that you have trouble managing your finances.
The aspect of balance reporting and credit utilization
Every month when you are planning to pay off your credit card bill, indirectly, you are affecting your credit utilization rate. If you are on the prospect of making a substantial amount of payment, you may be considering bringing your rate under 30%. Indeed, you may be frustrated if you do not see your credit score improving in a progressive manner. So, on the whole, it is important to understand your credit card utilization ratio. By default, you may find that your credit card score and the utilization ratio depend on when the company would be updating the numbers in your report! Typically, we can say that almost all of the credit card companies update the information every 30 days at the end of your billing cycle.
Are you thinking of improving your credit utilization ratio?
The first question that crosses your mind is: should you open credit cards to improve your credit utilization rate? Indeed, here are the ways through which you can manage your credit utilization ratio, follow on!
You must pay your credit card balances completely every month. Remember, even if you cannot get to the level “back-to-zero” each month, keeping your balances as low as possible can still be helpful. It helps you moving in the progressive direction without opting to keep the high stacks of debt for future payments.
Keeping open credit card accounts with zero balances can be a good idea for improving the rate. Remember, you can do this even if you intend to use it!
A good rule of thumb to remember when dealing with your finances and credit utilization is that it’s not necessarily about having too much credit, but how you manage your credit and accounts.