What Is A Credit Utilization Rate And How Does It Work
A credit utilization ratio is a figure that reveals the current utilization of a borrower’s total available credit. Credit reporting agencies often use the ratio to calculate a borrower’s credit score.
If you keep your ratio low, you can gradually improve your credit score. The utilization ratio makes up almost 30% of your credit score, making it the second most impactful factor that affects your credit score.
With increasing utilization, your credit score can go down. A high ratio indicates that you are paying more towards debt payments. The perceived chances of defaulting on your payments increase in such a scenario.
How Does The Credit Utilization Ratio Work
To form a better understanding of what is credit utilization, it is relevant to know that it depends on your revolving credit.
Revolving credit can be a line of credit or credit card that has a borrowing limit that allows for repeated borrowing unlike a single lump sum from a traditional loan. The ratio represents the total debt utilized by borrowers as compared to their total revolving credit limit.
Lenders see it as an important factor when considering approving a loan, besides other parameters like your credit history, credit score, and more.
Applications for loans and credit cards may potentially be rejected due to a high utilization ratio. Moreover, even if the applications are approved, you are likely to face bigger down payments or higher interest rates.
An Illustration Of The Working Of Credit Utilization Ratios
Here is an example of how credit utilization works.
Let us consider that, as a borrower, you have three credit cards with varying credit limits.
- Card 1: Credit limit $4,000, balance $1,000
- Card 2: Credit limit $9,000, balance $3,000
- Card 3: Credit limit $7,000, balance $2,000
The total revolving credit limit for all the three cards is $4,000 + $9,000 + $7,000 = $20,000
The total credit used is $1,000 + $3,000 + $2,000 = $6,000
The ratio is calculated as follows:
Credit utilization ratio = total credit used ($6,000) / total revolving credit ($20,000) = 30%
How Will The Credit Utilization Ratio Affect You?
As you make purchases and payments over a period of time your ratio will be affected. Your revolving credit account’s total outstanding balance gets reported to credit agencies throughout the month.
Credit utilization levels can also be affected by the time taken by your lender to report your credit balances to credit bureaus. Accordingly, it becomes important to understand that a decrease in utilization levels can take time. You can generally expect two to three credit statement cycles, even when you start clearing your debts regularly.
Things To Keep In Mind
When you are looking to change your utilization ratio, shifting balances from one credit card to another will not work. It is important to note that the ratio is calculated by dividing the total debt by your total revolving credit limits. However, it can be beneficial for you in the long-term, as the accumulation of lower interest can help keep the balances down.
When you close a credit card, it will hurt your credit score temporarily as you will end up reducing the total available credit you can have at a time and the age of your credit. Also, if you continue to carry the same balance on your remaining credit cards, your utilization ratio will spike higher. This will directly affect your credit score.
If you add a new credit card, your ratio will decrease. Though it will be helpful for your overall credit utilization, there is a downside as well. Your credit score may end up being temporarily impacted by the more limited account longevity and hard inquiries.
Your credit utilization ratio has a big impact on your credit score. Accordingly, it is vital to understand what it is, how it works, and what can be done to bring utilization below the 30% level preferred by lenders.
If you manage your utilization ratio efficiently, you can ultimately enjoy a higher credit score and the accompanying benefits.