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, if you have more than one credit card, the total of your combined balances relative to your total credit limit across all your credit cards. It’s expressed as a percentage and considered the second most important credit scoring factor after payment history.
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, your 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. This means that when FICO pulls information from your credit report to calculate your credit score, the ratio of your current balances to your available credit determines nearly a third of the calculation. Installment loan utilization is also factored into your credit score, but it has less impact on your score than revolving utilization.
Credit utilization is an important factor in your credit score because it demonstrates how you use the credit that’s available to you. If your credit utilization 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, your high credit utilization ratio may make lenders wonder if you’re under financial stress – or if your high balances indicate that you’re borrowing more than you can pay off.
See related: What affects your credit score?
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%. However, this rule is 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.
Know when your credit card issuer reports balances
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, this reporting happens once a month at the end of your billing cycle.
This means that if you make a payment that significantly lowers your credit utilization, it might not impact your credit score until the bureaus receive the updated report. Likewise, a big purchase right before a reporting period could make your credit utilization ratio appear higher than usual. Pay off your balances in full every month or make multiple balance payments throughout the month to keep your credit utilization ratio as low as possible whenever it’s reported.
Maintain a 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. A high balance on just one credit card may also have a negative effect on 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.”
Open new credit cards to increase your available credit
Getting a new credit card has the potential to improve your credit score. Every new credit card you receive gives you more available credit, which can lower your overall credit utilization ratio – as long as you don’t immediately turn that new credit into new debt. However, applying for a credit card triggers a hard inquiry into your credit that can have a negative impact on your credit score. New credit makes up 10% of your FICO credit score, and applying for too much new credit at once might hurt your score more than it helps.
That’s why it’s best to be strategic about your credit card applications. If the only reason you’re applying for a new credit card is to improve your credit utilization ratio, a better option might be to request a higher credit limit on one or more of your existing cards. Because this too can trigger a hard inquiry with some card issuers, always ask first to make sure it won’t.
Think carefully before closing old credit cards
Closing a credit card should be considered with even more caution. Closing a line of credit will reduce your total credit limit, which has the potential to raise your credit utilization ratio. Closing a credit card could also reduce the average age of your accounts. A closed account in good standing stays on your credit report for up to 10 years, but once that closed account falls off your report you might see a reduction in the length of your credit history and a drop in your score. Closing a credit card could impact your credit mix as well, if the credit card was your only revolving credit account.
If possible, avoid closing your cards. If you’re considering closing a card because you no longer want to pay the annual fee, you can call the issuer and ask to downgrade the card to a no-annual-fee version instead. That way, you can keep the account open and get the card terms that work better for you.
See related: ‘Upgrading’ to a no-fee credit card
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 – especially if you’re working to meet a sign-up bonus spend requirement.
The truth is, maintaining a 0% or close-to-zero credit utilization ratio on your rewards card is the best way to get the most out of your rewards card. 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 if you pay it off before your billing cycle ends.
“You maximize credit card rewards by never paying interest and maintaining a zero balance when your credit activity is reported to the bureaus,” says Adam Selita, CEO of The Debt Relief Company. “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.”
See related: Should I pay off my credit card balance all at once?
If you want to achieve a great credit score, it’s important to know how credit utilization works. Keeping your credit utilization ratio under 30% at all times, and aiming for less than 7% when possible, can help you maintain good or excellent credit. Since credit utilization ratio is the second-largest component of your FICO credit score, maintaining low balances on all of your credit cards will help you keep your credit healthy. Unsure of your credit utilization ratio? Use our credit utilization calculator to know where you stand.