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What Is A Credit Utilization Ratio And Why Does It Matter?

4-minute read

You know that lenders look carefully at your three-digit FICO® Score when determining whether to approve you for a mortgage, student, auto or personal loan. You know, too, that with a higher credit score you’ll qualify for the best credit cards at the lowest interest rates.

But did you know that something called your credit utilization ratio, which measures how much of your available credit you use, can drag down your credit score? It’s true. But if you have lower amounts of credit card debt, this same ratio can also give your credit score a boost.

In fact, this is why knowing what your credit utilization ratio is and how it works is so important for anyone applying for loans or credit cards.

What Is Your Credit Utilization Ratio?

As the name suggests, your credit utilization ratio measures how much of your available credit you’re using. And when it comes to your credit score, it’s best for your credit utilization ratio to be as low as possible.

Here’s an example: You have five credit cards. Two of them have credit limits of $5,000, one has a credit limit of $3,000 and two others have a credit limit of $2,000 each. That comes out to a total of $17,000 in available credit. Say that you’re carrying a balance of $10,000 total on the five cards. This leaves you with a credit utilization ratio of 58%, meaning you’re using 58% of your available credit. That’s a high credit utilization ratio.

Let’s say you have the same five cards with $17,000 of available credit. If you’re only carrying a combined total balance of $3,000, your credit utilization ratio is a far lower figure of about 17%.

Calculating your credit utilization ratio is simple. First, add up all the balances on your credit cards. Then add up the credit limits on all your cards. Divide your total balance by your total credit limit. Then multiply that number by 100 to see your credit utilization ratio as a percentage.

Why Does Your Credit Utilization Ratio Matter?

Your credit utilization ratio is one of the five key factors that myFICO says makes up your much-used FICO® Score. According to myFICO, your credit utilization ratio accounts for 30% of your score. That's second only to your payment history, which makes up 35% of your FICO® Score.

Xavier Epps, Founder and Chief Executive Officer of Alexandria, Va.-based firm XNE Financial Advising, LLC, said that having a low credit utilization ratio can save you money. That's because lenders look closely at your credit score when determining how much interest to charge you on loans. A lower credit utilization ratio can boost your credit score, making it more likely that you'll qualify for lower interest rates.

"This is important because lower interest rates reduce the amount of interest that you pay on a loan balance over time, which means that you can pay more toward principal and eliminate this debt sooner," Epps said.

What’s A Good Credit Utilization Ratio?

You might’ve heard that you should keep your credit utilization ratio at 30% or lower, meaning that you’re using 30% or less of your available credit. Some financial experts will recommend this. Others say that an even lower ratio, like 20%, is a better figure.

The truth is that there’s no single magic credit utilization number that’ll boost your credit score or send it tumbling. In general, though, the lower your credit utilization ratio, the better.

This makes sense. It’s always better to have less credit card debt than more. Instead of aiming for a specific ratio, concentrate instead on paying off your credit card debt.

Jake Sensiba, a financial advisor at CRG Financial Services, Inc. in Brookfield, Wis., said that your credit utilization ratio can play a major role in whether you qualify for a mortgage loan. That's because lenders look at your debt-to-income ratio (i.e., a measure of how much of your gross monthly income your total monthly debts consume) when considering your application for a mortgage. Most lenders want this ratio to be under 40%, Sensiba advised.

Having less credit card debt and a lower credit utilization ratio can help you earn a lower debt-to-income ratio, something that’ll boost your odds of qualifying for a mortgage.

Lenders also want to see a high credit score before approving borrowers for a mortgage. Your credit utilization ratio matters there, too.

"Credit utilization is incredibly important," Sensiba said. "It is the number-two factor when calculating your credit score."

Logan Allec, Founder of personal finance site Money Done Right and a certified public accountant based in Santa Clarita, Calif., said a high credit utilization ratio means that lenders are less likely to approve you for a loan or credit card.

A high credit utilization ratio shows that you’re not living within your means, and you can't even pay off debt you already have. "In your lender's eyes, your high ratio directly relates to you being a higher risk," Allec said.

Lenders, then, will either deny your request for a credit card or loan or charge you higher interest rates to make up for the increased risk of lending to you.

How To Improve Your Credit Utilization Ratio

Boosting this ratio isn’t complicated. You’ll improve your credit utilization ratio by paying down your credit card debt. The more debt you eliminate, the lower your ratio will be.

That’s the healthiest way to improve your credit utilization ratio. But you can also boost this ratio by increasing your available credit. If you have $5,000 in credit card debt, your utilization ratio will be lower if you have $20,000 of available credit as opposed to $15,000.

You can increase your available credit by either opening new credit card accounts or by calling your current card providers and asking them to increase your credit limit. Be careful, though: If you boost your available credit, you could run up even more credit card debt. That’s a big financial mistake.

One other tip: If you do pay off the entire balance on a credit card, don’t close that account. Doing so will immediately increase your credit utilization ratio even if you don’t make a single new charge. That’s because your available credit is reduced.

Say you have $2,000 of credit card debt and $10,000 of available credit. If you close a card with a credit limit of $3,000, you now have $2,000 of credit card debt and available credit of just $7,000. That’ll increase your credit utilization ratio.

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