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Understanding Your Credit Utilization Ratio and its Impact on Your Credit Score
In the United States, your credit score, a numerical representation of your creditworthiness, plays a significant role in various financial activities, including securing loans and opening new credit lines. It can even influence your auto insurance premiums depending on your location. While payment history is the most dominant factor in determining your score, your credit utilization ratio is another critical element to consider.
This ratio, expressed as the percentage of your total available credit being used, can impact between 10% and 30% of your credit score. Especially if you have a modest credit limit, lowering this ratio can be an effective strategy to improve your overall creditworthiness without significant effort.
Deciphering Credit Utilization Ratio
If you are unclear about how exactly credit utilization ratio functions, we can clarify its effect on your credit score. We also offer actionable tips and tools to help you decrease your credit utilization and subsequently elevate your score. To delve deeper, you might explore insights on maintaining an exceptional credit score above 800 or understand the operations of the three primary credit reporting agencies.
Defining Credit Utilization Ratio
Your credit utilization ratio is the proportion of your accessible credit that you are currently utilizing. For instance, if you possess a single credit card featuring a $1,000 limit and your present balance is $200, your credit ratio is calculated as $200 divided by $1,000, resulting in 20%.
VantageScore calculates your credit utilization ratio solely based on revolving credit, specifically credit card accounts. FICO, conversely, incorporates your credit ratio within its “Amounts Owed” category, reflecting your total debt burden.
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Total vs. Individual Account Ratios
It’s crucial to note that both VantageScore and FICO assess your total credit utilization – considering balances and credit limits across all your credit cards – alongside the ratios for each individual account. Even if your aggregate ratio is reasonably low, having a single card maxed out can negatively affect your credit score.
Reporting Timelines and Statement Balances
Perhaps more importantly, credit bureaus don’t determine your credit utilization ratio using real-time credit card balances. Instead, they utilize the balances reported by your credit card issuers. While each issuer operates under its own system, the reported figures often correspond to the balances reflected in your monthly statements.
Thus, even if you diligently pay off your credit card balances monthly, maintaining a high credit ratio at any point during your billing cycle could be detrimental to your credit score.
Understanding a Favorable Credit Utilization Ratio
“It is generally advisable to maintain your credit card balances at or below 30% of your assigned credit limit,” Bruce McClary, Senior Vice President at the National Foundation for Credit Counseling, told FASTNET.
According to CBS News MoneyWatch, a credit utilization ratio of 50% or greater could potentially decrease your score by 50 to 100 points, while a maxed-out ratio of 90% or more may lead to a reduction of 100 points or more.
While adhering to a 30% or lower credit ratio is a common recommendation, individuals aiming for exceptional credit scores should strive for even lower ratios. Experian, a credit rating agency, suggests, “If your goal is to achieve excellent credit scores, a credit utilization ratio in the single digits is optimal.”
“In reality, lower balances are always preferable. Higher balances have a greater potential to negatively impact your score,” stated Todd Christensen, Education Manager at Money Fit.
However, a 0% credit ratio is not the ideal target. Experian also points out that “the only guaranteed way to maintain 0% utilization consistently is to completely abstain from using your credit cards.” This approach, however, could lead to issuers closing your accounts, thereby reducing your total available credit and inadvertently increasing your ratio.
Strategies to Decrease Your Credit Utilization Ratio
Since the credit ratio represents debt divided by credit limit, the primary methods to lower this ratio involve reducing your debt and increasing your credit limit. Below are effective strategies to achieve this.
Implement Bi-Monthly (or More Frequent) Credit Card Payments
Credit card companies routinely report your balances to credit bureaus, often based on your credit card statements. Even if you consistently settle your credit card bill each month, a statement displaying a balance that constitutes a high percentage of your credit limit can negatively impact your credit score.
If you are a frequent credit card user, consider making payments twice a month, or whenever your balance approaches 30% of your credit limit. Online credit card platforms simplify the process of making or scheduling multiple payments, and you can configure balance notifications (explained below).
For instance, with a $1,000 limit and monthly spending of $900, a 90% credit utilization ratio will almost certainly harm your credit score. However, if you make payments as your balance reaches $300, or three times per month, you can mitigate the negative impact of a high ratio on your score.
Set Up Credit Card Balance Alerts
Many credit card providers now offer online account alerts, including balance notifications. These alerts can be delivered via email, text message, or through your credit card provider’s website.
To safeguard your credit ratio, configure an alert to notify you when your balance hits 25% of your credit limit. This buffer provides a safety margin to ensure you remain below the recommended 30% threshold.
Request a Credit Limit Increase
Raising your credit limit can effectively lower your credit ratio because your outstanding balance then represents a smaller fraction of your maximum borrowing capacity. Requesting a credit card limit increase is generally straightforward – simply call the customer service number on the back of your card to speak with a representative.
However, before requesting an increase, keep several factors in mind. This strategy is only beneficial if you refrain from increasing your spending. If a higher limit tempts you to incur more debt, it might be prudent to reconsider.
Additionally, inquire with the credit card representative whether the company will initiate a hard credit check before approving your request. While a higher limit can improve your ratio, a hard inquiry could temporarily lower your credit score by a few points for up to a year.
Retain Older Credit Cards and Use Them Periodically
If you possess older credit cards that are rarely or never used, avoid closing them. Canceling them will only diminish your overall available credit and negatively affect your credit ratio, as well as potentially shorten your average credit age.
However, issuers may close inactive accounts due to lack of use. To prevent this, use older cards sparingly, perhaps for a small purchase every few months. This keeps the accounts active and maintains your total available credit at a higher level.
Conclusion
Understanding the principles of credit utilization ratio empowers you to employ these strategies to decrease your ratio and strengthen your credit score.
For further insights, explore our recommendations for the best credit cards designed for building credit.