There are five major factors that influence a person’s credit score: payment history (35%), level of debt/credit utilization (30 percent), age of credit (15 percent), mix of credit (10 percent), and credit inquiries (10 percent).
In the world of credit scores, paying off your credit card on time is not the only issue; how much of your credit balance you use up also matters.
This means that your credit utilization ratio, or how much of your available credit you actually use, accounts for a huge chunk of your credit score.
For example, if your balance is $500 and your credit limit is $1,000, then your credit utilization is 50%. To find out your credit utilization simply divide your credit card balance by your credit limit then multiply by 100.
Simply put, your credit utilization rate is how much debt you have compared to how much credit you have available, or “debt to available credit ratio.”
As a general rule, the less amount you use, the better for your score.
Why? Using a smaller percentage of your available credit makes you look like less of a risk to a bank, and less-risky borrowers get the best interest rates.
How does my credit utilization rate influence my score?
Your credit utilization rate is used two ways in calculating your score—on aggregate (the sum of all your balances divided by your total credit limits) and individually (the same ratio for each individual card). Sometimes, it’s better to have that $4,000 debt spread among the three cards rather than having it all on one card that would likely have an unacceptably high utilization rate.
Experts say that the higher balance you have in relation to your credit limit, the more likely it is that you default on your loan. This is reflected in a lower credit score.
If your credit utilization rate is high, it looks as though you’re living on the edge, and that alone will hurt your credit score.
Also, don’t let anyone make you believe that you need to carry balances to give your score a boost. Karen Carlson, director of education for the non-profit agency InCharge Debt Solutions, says, “I have never seen a credit scoring model award points for that. It’s really about the account being paid as agreed.”
How will it affect my finances?
High utilization can lower a credit score, which will, in turn, raise your interest rates. Let’s say you have a 650 credit score and your credit card rates revolve around 18%. Had your credit score been 760 or above, your interest rate would drop to only around 8%. It means you save $1000 a year in interest for every $10K you carry in balance. It can also add nearly 1% to your mortgage interest rate, costing you tens of thousands of dollars over the lifetime of your mortgage.
What is the ideal credit utilization ratio?
We’ve established that your credit utilization rate is so important to your credit history and a score that you must always keep on top of your usage.
While there is no perfect utilization rate, John Ulzheimer on Mint.com states: “The way the scores are designed rewards consumers for having a lower rather than higher utilization.”
This means the lower your utilization score, the better.
When you have two credit cards with a combined credit limit of $10,000 and your total balance is $4,000. Your credit utilization is 40 percent. For most lenders, it is not a good number. Finance experts recommend keeping your utilization below 30 percent.
As an option, you can pay up and reduce your balance to $2,500, then your credit utilization ratio falls to an acceptable 25 percent. This will increase your score but not immediately, since banks typically only report cardholders’ balances about once a month. The lower your credit utilization rate, the more your score can climb.
How can I lower my credit utilization rate?
One good way to reduce credit utilization would be to pay off existing balances. Make it a goal to get a utilization rate of less than 25 percent.
Examine your credit card statements and figure your own utilization rate and how much debt you’d need to lose to get that rate down to an acceptable level. Then, come up with a plan to use to raise the cash you need. If your monthly salary is not enough to cover everything, sell something of value that you own. Put in extra overtime at work. Do whatever you need to do to raise that money, as long as you don’t put yourself in a short-term financial bind in the process.
Work on reducing your debt so that you’re utilization rate is on a good level on all your revolving credit accounts. Ideally, you should only charge what you can pay in full each month which means you aren’t using credit to live beyond your means.
Another way is to add more to your limit by taking out additional credit. The danger with this option is that opening more accounts tends not to work very well. Your credit score will take a hit from the additional inquiries when you open an account and second, despite best intentions, that open balance tends to get spent, leaving the borrower even worse off.
Do you have a good credit utilization rate? What steps did you take to get there? Share them in the comments below.
The post How Your Credit Utilization Ratio Affects Your Credit Score appeared first on Credit Data.