Credit utilization is the second most important factor in credit scoring. Knowing how to maintain a good rate may help you reach a higher credit tier.
A credit utilization ratio is the balance on your credit card relative to that card’s credit line – or the total of your balances relative to your total credit limit. It’s expressed as a percentage and considered the second most important credit scoring factor after payment history.
See related: What affects your credit score?
Why is this number so significant? And how do you improve it? Read on to learn how credit utilization affects your scores and what you can do to keep the optimal ratio.
Why is a credit utilization ratio important?According to the FICO scoring model, credit utilization ratio accounts for 30% of your credit score. It’s based on your revolving credit – your credit card usage and lines of credit. Installment loan utilization is also factored into your credit score, but it has less impact on your score than revolving utilization.
Credit utilization is such an influential factor in your credit score because it demonstrates how you use credit that’s available to you. For instance, if your ratio is low, it can serve as an indication that you’re managing credit well and aren’t prone to overspending. If, on the other hand, you tend to max out your credit cards, it may be interpreted as a sign you’re under financial stress or tend to borrow more than you can pay off.
How is a credit utilization ratio calculated?
To calculate your credit card utilization ratio, divide your current balance by your credit limit. For example, if you owe $1,000 on a credit card with a $10,000 credit line, your credit utilization ratio is 10%.
To find your total credit utilization ratio, divide the sum of all current balances by the sum of your credit limits. For instance, if you owe $200 on a card with a $5,000 credit line and $300 on a second card with a $1,000 credit line, your total credit utilization is around 8% (a $500 total balance divided by $6,000 in total available credit).
What is the best credit utilization ratio?
A good rule of thumb is to keep your credit utilization under 30%. It is, however, not set in stone.
“There’s definitely no hard-and-fast rule when it comes to determining the percentage to use to maintain a good or even excellent credit score,” explains Anna Barker, personal finance expert and founder of LogicalDollar. “That said, the 30% rule has become widely considered as the tipping point. While it’s not a bad number on which to base your utilization rate, there’s no set number for calculating this, especially when you consider how many other factors go into calculating your credit score.”
While the 30% rule can be a good benchmark, it’s best to aim to keep your credit utilization as low as possible – ideally in single digits.
“Several years ago, I had an expert from Experian on my podcast, and she mentioned keeping credit utilization below 30%,” Robert Berger, deputy editor of Forbes Money Advisor and author of “Retire Before Mom and Dad,” said. “It turns out that 30% is not a magic number. In fact, people with scores of 800 and higher typically use just 7% of their available credit.”
How to improve your credit utilization ratio
Now that you have an idea of what ratio you should be aiming for, you can start thinking of the strategies you can use to achieve it.
Consider balance reporting
First, it’s useful to know how credit reporting works in regard to card balances. Each credit card company has its own schedule of when it reports to credit bureaus. Typically, it happens once a month at the end of your billing cycle.
You may make a payment that you know will significantly lower your credit utilization and not see any impact on your credit for a few weeks. While it can be frustrating, stay patient and make a point to keep the ratio low at all times to ensure it’s where you want it to be whenever it’s reported.
Maintain healthy credit utilization on every card
It’s essential to be mindful about both your total credit utilization and per-card utilization. Even if you keep your total ratio low, a high balance on one of your credit cards can be a red flag to lenders. It may also affect your credit scores.
“This is important to keep in mind to avoid taking any action that you think may be helping your credit score, when it’s actually hurting it,” Barker says. “One example is if you’ve maxed out one card and open another where you maintain the balance at zero to try to counter-balance the first one. In this case, the total utilization of the first one may still negatively impact your score.”
The best way to avoid such issues, Barker suggests, is making sure you don’t come close to the limit on any of your cards.
“That way, both points are addressed at the same time.”
Leverage new credit cards to optimize credit utilization
As you can see, how you manage your credit cards plays a critical role in your credit utilization ratio.
This goes beyond simply keeping your balances low. It’s also important to remember how opening and closing a credit card can impact the ratio – and your credit.
Getting a new credit card can be beneficial for your scores since it gives you more available credit, which can lower your overall utilization. However, a new account can also lower your credit age and add to new credit, negatively impacting your score. Not to mention, applying for a credit card triggers a hard inquiry.
That’s why it’s best to be strategic about your credit card applications. Consider why you’re looking into getting a new card to make sure it’s the best move. If the only reason is credit utilization ratio, a better option might be requesting a higher credit limit on your existing cards.
Don’t forget about older accounts
Closing a card should be considered with even more caution. Such a step would lower your credit utilization, and it could eventually reduce the average age of your accounts (a closed account in good standing stays on your credit report for 10 years). It may impact your credit mix as well if the card is your only revolving credit account.
If possible, avoid closing your cards. If you’re considering it because your card’s annual fee doesn’t justify itself, you can call the issuer and ask to downgrade the card instead. That way, you can keep the account open and get the card terms that work better for you.
How to minimize credit utilization while maximizing rewards
You may be wondering how keeping your credit utilization low can impact your credit card rewards. It’s a valid question since more spending on a credit card translates into more cash back, points or miles. It’s especially true when you’re working to meet a sign-up bonus spend requirement.
The truth is, maintaining a 0% credit utilization ratio on your rewards card is the best way to get the most out of your rewards card.
“You maximize credit card rewards by never paying interest and maintaining a zero balance when your credit activity is reported to the bureaus,” Adam Selita, CEO of The Debt Relief Company, explains. “Paying 20% interest on a credit card that offers 2% cash back is moot. This is definitely not the right way to maximize your benefits since you are giving back whatever rewards you may have accrued.”
One way to go about it is to treat your rewards card like a debit card. If you charge a significant amount on it, pay it off right away. This will help you make sure you won’t pay interest and the high balance won’t be reported.
There might be no magic number for credit utilization, but keeping it under 30% and aiming for less than 7% can be good guidelines. Since credit utilization ratio is a crucial credit factor, maintaining low balances on all of your credit cards will help you keep your credit healthy.