This blog post was written by Student Advisory Council member, David Gonzalez.
A pillar to financial health is a great credit score and keeping track of the various contributing factors can seem like a task shrouded in mystery. One factor particularly stands out among the rest as one the least understood, enveloped in countless misconceptions: credit utilization ratio. Here’s a quick rundown.
Definition
In simple mathematical terms, your credit utilization ratio is:
(currently utilized credit) ÷ (total credit limit).
In other words, it is simply how much of the total credit limit you are currently using across all accounts. “Across all accounts” is a key phrase here. Understandably, many mistakenly believe that their credit utilization ratio is calculated separately for each individual credit line account, but this is not the case.
Why is it important?
As roughly 30% of how overall credit score is calculated (in some models), your credit utilization ratio is the second largest contributing factor behind payment history (35%). It can signal to lenders the degree to which you may rely on their credit, contributing to how much a lending risk you appear to them. Your remaining credit card balance is often reported to credit bureaus at different times within the billing cycle, so you can have a high credit utilization ratio despite paying off your entire monthly balance.
So, keeping this figure healthy is a priority.
What is a healthy ratio?
Your utilization ratio will fluctuate according to your spending and payments. As a result, it is important to be conscious of your debt at any given point. As always, the lesser the debt, the better. A lower utilization ratio is preferred to a higher one. A rule of thumb is to keep it below 30%. (You can convert your credit utilization ratio to a percentage by multiplying it by 100.)
To lenders, a lower utilization ratio indicates that you A) can responsibly handle credit and similarly, B) do not depend heavily on their credit.
General Tips
- If you are considering closing a credit account, keep in mind that it may significantly harm your credit score. This is, in part, because closing a credit line means shrinking your total credit limit (also called “revolving credit”) and subsequently, increasing your utilization ratio. It may be better, in many cases, to simply leave your credit cards open, even if you rarely use them.
- To decrease your credit utilization ratio, you can request your credit lender for a limit increase. This tip should be approached with caution, however, since some lenders may pursue a hard inquiry into your credit report. A hard inquiry will drop your credit score by a few points.
- Compared to paying off your statement balance once a month, credit bureaus will note lower utilization ratios if you pay off your statement balance more than once a month.
