Credit Utilization Ratio and How to Keep it Low

What is credit utilization?

Credit utilization is the ratio of your credit balances to the total credits available to you. It is usually expressed in percentage. That is why people usually refer to it as credit utilization ratio or credit utilization rate. Some people may even be more specific by calling it credit card utilization ratio. Whatever the name you call it, it means the same thing. The two main elements involved that you need to consider while calculating credit utilization are your card balances and your total credit limits. You simply divide your card balances by your total credits and then multiply the answer by 100. However, if you have other revolving credits such as lines of credits apart from your credit cards, this will be added when calculating your credit utilization ratio. Please note that instalment loans such as mortgage loans and auto loans are not considered here. Mortgage loans and auto loans are relevant when calculating your debt-income ratio.

Credit utilization ratio is calculated in two levels if you hold more than one credit card. It is calculated at per card level and at total card balances level. The same way you calculate it on the card level is the same way you calculate it on individual card is the same way it is calculated on total card balances. The only difference is that, while calculating the credit utilization on total card balances, you need to add up all the credit card balances together and then divide result by the total credits available on all the credit cards.

Your credit utilization carries 30% weight in the calculation of your credit score. That is to tell you how important it is. By standard, it is expected that your credit card utilization ratio should not be more than 30%. The lower the ratio, the better the effects on your credit score. On the other hand, any rate higher than 30% may have adverse effects on your credit score. It is important to mention again that your credit card utilization only account for just 30% of what go into the calculation of your credit score. Therefore, having a good credit card utilization ratio is not a guarantee that you will have good or excellent credit score. The credit rating agencies consider other factors such as your payment history, age of credit, credit mix and credit inquiries in determining your credit score. However, if your credit utilization is perfect, it can help you improve your credit score.

I believe everything may still sound like theory to you. So, let’s go practical now. We shall look at how credit utilization ratio is calculated. Also, we shall look at how the balances on different credit cards can impact your overall credit card utilization ratio.

Example 1

Mr A has only one credit card with a credit limit of $1,500. The card balance at the end of the month is $300.

To calculate the credit utilization for Mr A, you will divide $300 by $1,5000 and then multiply by 100. The answer is 20%. This is less than 30%. It is then considered a good credit card utilization rate.

Example 2

Mr B has three credit cards. The details of each card are as follows:

Card Balance Credit Limit
1 $300 $1,500
2 $400 $1,000
3 $2,500 $12,000
Total $3,200 $14,500

Going by our formula, the credit utilization ratios for cards 1, 2 and 3 will be 20%, 40% and 20.83% while the overall credit cards utilization ratio is 22.07%. Mr B overshoot the benchmark of 30% on Card 2 but the lower credit utilization rates on Cards 1 and 3 were able to drag the overall ratio down to 22.07%. This is still good but it is advisable to keep the credit utilization ratio on each card below 30%.

Example 3

Mr C has three credit cards. The details of each card are as follows:

Card Balance Credit Limit
1 $150 $1,500
2 $150 $1,000
3 $4,200 $12,000
Total $4,500 $14,500

You will notice that all the information in our example 3 is the same with that of example 2 except that the balances on each card are different. Let’s look at the results. The credit utilization ratios for cards 1, 2 and 3 will be 10%, 15% and 35%.  Ordinarily, when you compare these ratios with our second example above, one may jump into conclusion that Mr C was able to manage his credit better.  Credit rating agencies or prospective lenders may look at it differently. They may likely pay more attention to the overall credit utilization ratio. In this example, the overall credit utilization ratio is 31.03% compared to 22.07% in the second example.  How? Are you confused? The main difference in the two examples is the total balances that Mr B and Mr C had on their credit cards. Mr B only exceeded 30% benchmark on Card 2 that is having just $1,000. Therefore, the effect is not significant on the total available credit of $14,500. Even if Mr B exhausted the whole $1,000 which is not advisable anyway, his total credit cards balance would have been $3,800 while his overall credit utilization ratio would have still remained at 26.21%. On the other hand, Mr C spent more on the card with the highest credit limit. Therefore, the effect of the 35% credit utilization on the card nullified the low credit utilization rates on the other two cards. While it is important to pay attention to the credit card utilization ratio, it is more important that you are careful about the balance you carry on your card in relation to the total credits available to you.

How to maintain a good credit utilization ratio

There are basic strategies one can use in order to maintain a good credit card utilization rate.

Reduce your card balances: You can reduce your credit card balances by cutting down the amount of transactions you make on the cards. Stop making large purchase with your cards. You can be using your cards to pay for less expensive items such as groceries. Another strategy you can use is to ensure that you pay off your balance. Please you need to understand that transferring a card balance from one card into another card may not have any impact on your credit utilization except you pay the balance. Also, it is not automatic that paying off your balance will have any effect on your credit utilization. The payment has to be made before your credit card statement date. Credit rating agencies do not base their calculation on spending you made with your cards. They base their calculation on the card balances on the statement date. Your cards issuers will normally report your balances to the credit rating agencies on your statement date. Therefore, it means that you can beat the system by ensuring that you pay off your cards balance before the statement date. If you cannot pay off the balance completely, you can pay a considerable amount that will bring your credit utilization ratio below 30%. In case you don’t know your statement date, you can ask from your credit card issuer. Since you will need to pay before you receive your credit card statement, you may need to set alerts to serve as reminders so that you don’t forget.

You may not want to be carrying zero balance on your statement so that you can demonstrate to anybody or organization that may place inquiries on your credit that you are creditworthy. If you carry zero balance, lenders may not see any proof of how effective you are in managing credit. For this reason, you may maintain a balance that will put you above 0% but lower than 30% credit card utilization rate. However, you should ensure that you pay off the balance at the end of your billing period so that you don’t need to pay interest unnecessarily.

Increase your credit limit. You can increase your credit limits by two ways. You either ask your credit card issuer to increase the credit limit on your existing credit card or you apply for a new card. If your credit limit increases while you keep your spending at the same level, your overall credit utilization ratio will reduce. But you need to approach this strategy of opening new credit card with caution. You should not just apply for new card for the purpose of enhancing your credit utilization ratio. Applying for too many cards may hurt your credit score in short term. Each time you apply for credit, the lender will place a hard inquiry on your credit. For this reason, you may realise that your credit score drops a little.

Read Also: A Guide on How to Increase Your Credit Limit

Keep your credit card with nil balance open. While this may not improve your credit card utilization rate, closing an existing credit card with nil balance may increase it and then hurt your credit score. If you don’t owe any balance on any of your cards, closing a card may not have any impact on your credit utilization ratio. Nevertheless, you may need to consider the impact this may have on your credit history. Don’t forget that your credit history is a major factor used in calculating your credit score. Therefore, for this purpose, it may be nice to keep the card open. Before I conclude this article, let me show you how closing a credit card with nil balance can affect your credit utilization. I want everything to be practical so that you can fully understand the topic.

Example

Let’s assume you have the following cards as indicated below:

Card Balance Credit Limit
1 0 $3,000
2 $900 $3,000
3 $580 $2,000
Total $1,480 $8,000

The credit utilization of each card is as follows: Card 1, 0%; Card 2, 30% and Card 3, 29% while the overall credit cards utilization ratio is 18.5%.

But if you decide to close Card 1, your available credits will drop to $5,000. Therefore, your new overall credit cards utilization ratio will increase to 29.60%. You can see the impact this is having. Any slight increase in the balance of any of the remaining two credit cards will not only increase the credit utilization of the card, it will make the overall credit utilization ratio to jump above 30%. It may not be overruled that there will be some time you need to make emergency payments. For this reason, it may be better to keep your cards with nil balance open.

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