The information provided on this website does not, and is not intended to, act as legal, financial or credit advice. See Lexington Law’s editorial disclosure for more information.
Key takeaways:
Credit cards can be an incredibly useful tool. Not only do they give you additional funds to make a big purchase or help in an emergency, but if used responsibly, they can help you build credit. As a credit card user, you should always be aware of your credit utilization, or the amount of money you borrow compared to your credit limit.
Your credit utilization can have a significant impact on your credit. Read on to better understand what credit utilization is, how to calculate and how to improve it.
Credit utilization looks at your outstanding debt and compares it to your revolving credit limits to determine how much of your available credit you are using. Low credit utilization is a positive indicator because it shows that you’re only using a small amount of the credit that’s been loaned to you.
Remember that the utilization rate refers to revolving credit only—credit without a specific end date. Home and auto loans do not apply in this category, as you have agreed to pay those lenders within the specified time period. Revolving credit usually includes credit cards and personal loans.
Your credit score is a statistical summary of the information contained in your credit report, usually based on a scale from 300 to 850. Credit scores are intended to be generated without bias—they do not take into account factors such as age, gender or race.
There are five major factors that impact your FICO credit score:
Your utilization rate accounts for 30 percent of your credit score. FICO® suggests keeping your utilization rate under 30 percent, but the lower, the better. If you have higher credit utilization (above 30 percent), your credit will likely not improve much until you’ve paid off some of your revolving credit balance.
Use this method to determine your credit utilization rate:
The formula is simple enough if you only have one credit card. For example, if you are using $100 of a total credit limit of $1,000, you’ll divide 100 by 1,000 to get 0.1. Multiply by 100, and your credit utilization rate comes out to 10 percent.
It works the same way if you have more than one source of revolving credit. Let’s say you have three different credit cards with a total of $20,000 available in credit. On one of these cards, you may owe $500 against a limit of $5,000 (10 percent).
On another card, you may owe $250 against a limit of $5,000 (5 percent). On the third credit card, you may owe $8,000 against a limit of $10,000 (80 percent). That 80 percent ratio is an example of high utilization, which can drag your credit down, even though the ratios on the other two cards are good.
This is because the average utilization ratio of all your accounts is used to help determine your credit score. In the example above, your average utilization ratio for all three credit cards is 44 percent.
Poor credit can make it very difficult to secure a loan or a new line of credit. Fortunately, working on your credit utilization is one of the quickest and easiest ways to improve your credit.
Your score is generated by an algorithm that pulls from different sets of data—one of which is your credit utilization rate. If you are utilizing more than 30 percent of your available credit, there are steps you can take to quickly improve it, which can, in turn, improve your overall credit.
Paying down debt is the most important step you can take to help your credit. This means you need to pay more than the minimum amount due on your credit card bill each month. It’s also a good idea to make extra payments when and where you are able to do so.
You can make a plan for each credit card and tackle them one at a time. For many people, the top priority is to pay off the credit card with the highest interest rate. Other people opt to pay off the credit card with the lowest balance first, as this can give you a sort of mental boost. The most important thing you can do is make a plan and stick to it.
If you have multiple credit cards, you may consider consolidating them and paying them down with a personal loan. If your cards have interest rates in the 15 to 20 percent range, but you secure a loan with a rate of 10 percent, you can end up saving some money.
This can be a dangerous proposition for those who often want to spend. If you can resist the temptation, however, getting a credit limit increase can actually improve your credit utilization ratio. Suddenly, your $2,000 debt looks much better against a limit of $15,000 versus the previous max of $8,000. In other words, the ratio decreases from 25 percent from 13 percent.
Remember that asking for a credit limit increase will cause a hard inquiry. This will temporarily hurt your credit, but if your credit limit is increased, it will likely help you more than hurt you.
Some credit card companies periodically review your account and will give you a credit limit increase. If this is the case, you’ll avoid the hard inquiry and see your utilization ratio drop.
After paying off a credit card, you may be tempted to close out the account. If you leave the card open, the amount still factors into your available credit, which improves your credit utilization ratio. An open card also factors into your credit age, which accounts for 15 percent of your score. If you’re afraid of racking up debt again, you may want to consider keeping the credit card physically out of your wallet or cutting up the card.
While credit utilization is important, remember it’s only one component of your overall credit health. Take a proactive stance against bad credit by regularly reviewing your credit report for errors or other negative marks. If you need help addressing any errors or otherwise repairing your credit, the team at Lexington Law Firm may be able to help. Get a free credit assessment and learn more about how we can help you work on your credit today.