Everyone knows you need a good credit history to achieve a good or excellent credit rating.
But what most people don't know is that credit history is just one of the factors considered in the credit scoring models that determine what is a good credit score.
Even fewer know about another influential factor - credit utilization. Knowing how to use the credit utilization ratio to protect and improve your credit is practically a secret.
Learn how to arrange your finances to take full advantage of this powerful ratio so you can get a higher credit score.
What is Credit Utilization?
Credit utilization is the relationship between the amount of revolving credit you have and the amount you're currently using.
If your credit card limits total $10,000, for example, and your balances against those credit lines total $9,000, your credit utilization ratio is 90%.
Note that the credit utilization rate only applies to revolving accounts - credit cards and lines of credit. The credit utilization ratio does not incorporate the balances of installment accounts like your auto loan or mortgage.
How Credit Utilization Can Affect Your Credit Scores
A lower credit utilization ratio will affect your credit scores in a good way. Higher credit utilization ratios can harm your credit score considerably.
This is confusing to consumers because most people think that if you have credit, you should be able to use it.
And credit card issuers don't disagree.
As long as your account is in good standing, you can borrow all the way up to your limit. You can carry that balance indefinitely if you make your minimum payment on time and don't exceed your limit.
Why is High Credit Utilization Bad for Your Credit Score?
Credit scoring models penalize you for having a high credit utilization ratio. That's because, statistically, consumers with high utilization are more likely to declare bankruptcy.
If your credit card balances increase month after month, you're probably spending more than you're taking in.
That's not a sustainable practice, though. Eventually, you won't be able to make your minimum payments and your finances will collapse.
Credit scoring models pick up on this red flag quickly and reduce your credit score as your utilization increases.
What is a high credit utilization ratio?
People in the worst FICO score range use 80% or more of their credit.
Those in the very bottom credit tiers use more credit than they have - probably indicating missed payments and penalties.
What Is a Good Credit Card Utilization Ratio?
Credit utilization is nearly as important as credit history - your payment history comprises 35 percent of your credit score, and your credit utilization makes up 30 percent.
Utilization for consumers in the "excellent" FICO score range is under 10%, according to MyFICO.com. And those in the "good" range use less than 20%.
Most personal finance sites recommend keeping credit utilization below 30% to protect your credit score; but when it comes to credit scoring and credit utilization, less is truly more.
"Per Account" Utilization - Why You Shouldn't Go Over Limit
While the most important consideration is utilization of your total credit limit, how much you use each credit card account or credit line also impacts your FICO score.
The per account or per card utilization doesn't impact your score much - a high credit card utilization ratio on one account is offset by a low rate on another - unless you go over-limit on one card.
You can't offset the impact of being over-limit on one account by opening another and having zero utilization on it. The over-limit account will still hurt you, even if your total utilization is lower.
Improve Your Credit Utilization; Raise Your Credit Score
There is good news if your credit score is low because of high credit utilization.
Unlike credit history, which can take years to build or rebuild, credit utilization can be changed very quickly. There are several ways to accomplish this.
Apply for new lines of credit
You can reduce your credit utilization by increasing the amount of available credit.
If you have a $1,000 credit card limit, and your balance is $800, your utilization is 80%. But if you get a new credit card with a $2,000 limit, your utilization immediately drops to 27%.
You calculate it this way: $800 outstanding credit balance / $3,000 total available credit = 27%.
How to calculate your credit utilization
Outstanding credit balance / Total available credit = Credit utilization ratio
Your credit score will take a couple of small hits when you open the new account - first, because applying for a new credit line generates at least one inquiry on your credit report and, second, opening a new line of credit lowers the overall age of your accounts.
Pay down your balances
Opening a new account does increase the amount of available credit, but it does not reduce what you owe.
In the example above, your balance is still $800. And if you have a hard time resisting the temptation of a new credit card burning a hole in your pocket, adding to your available credit is not great for your future financial security.
Putting your credit card on ice and paying down the existing balance is probably a better idea for you. Not only will you improve your credit score by reducing your utilization; you'll actually reduce your debt and become more financially secure.
It's not exciting, but it is smart.
Replace revolving debt with personal loans
If you have a lot of revolving debt, you can improve your credit score instantly by paying it off with a personal loan. Personal loans are installment loans, so their balances don't count in your credit card utilization rate.
Here's how you make this work:
- You use the personal loan to clear your revolving balances. This is often called "debt consolidation." Your credit utilization ratio drops to zero and your FICO score improves almost immediately.
Understand, however, that your debt does not magically disappear - you still owe the money!
Approximately 85% of consumers who consolidate credit card debt fail to leave their cards alone and run their balances back up. Then they end up worse off than before, with maxed-out cards and new installment balances as well.
If you are not 100% sure that you can be disciplined about your future spending, this is not the solution for you.
Balance transfer cards
Balance transfer cards are available to consumers with good-to-excellent credit. They offer an introductory 0% interest period in which every cent you pay goes toward reducing your balance. There is no interest accrued.
These accounts help you boost your FICO score in two ways:
- Opening a new card adds to your available credit and thus reduces your credit utilization.
- The 0% interest period, which can run from six to 24 months, allows you to accelerate your debt repayment.
While there is a charge for transferring balances, usually 3%, the savings realized almost always outstrips this charge by miles.
What about home equity loans or HELOCs?
You can definitely use home equity financing to pay off credit cards, and your utilization and credit rating improve immediately.
However, there is a caution.
Home equity financing allows you to stretch the repayment of your debt out over a very long period of time. Even if your interest rate is much lower, you'll probably pay more interest.
For instance, if you a have a $5,000 credit card balance with a 15% credit card rate and a $150 payment, you'll clear your debt in 43 months and pay $1,507 in interest. If you pay it off with a home equity loan at 7% over 15 years, your payment will be just $45 per month but you'll pay $3,089 in interest.
You can use home equity loans to repay credit card debt and improve your credit rating, but it's smart to accelerate your repayment to avoid excess interest.
At 7% over three years, you could pay $154 per month and your interest charges would drop to $557.
Home equity is fine for debt reduction but focusing only on the payment could cost you in the long run.
How to Time Credit Utilization
If you are applying for a loan like an auto loan or mortgage, you'll want your FICO score to be as high as possible to get the best deal - and that means paying attention to your utilization.
Avoid adding to your credit card balances before applying for your loan. And give your payments plenty of time to process.
Your utilization won't drop the minute your credit card issuer receives your payment. It must be processed, and then your payment has to be reported to the big three credit bureaus - Experian, TransUnion and Equifax. This can take a day, a week or more.
Experian says, "Typically, credit card companies update this information every 30 days at the end of your billing cycle. It's possible that you could make a payment on one of your credit cards but not see the impact on your credit scores for a few weeks."