Your credit utilization ratio, although often overlooked, is a key factor in determining your creditworthiness. In simple terms, it represents the amount of debt you have compared to the total credit available to you.
By managing your credit utilization effectively, you can boost your credit score and enhance your eligibility for future loans and credit opportunities. Read on to learn more about credit utilization and discover the strategies to improve your financial standing.
What is credit utilization?
Credit utilization – also known as your credit utilization ratio or credit utilization percentage – is the amount of debt you have in comparison to the amount of credit that’s available to you.
How to Calculate Your Ratio
You can calculate your credit utilization ratio by making a list of all of your revolving credit accounts. That means any credit cards or lines of credit you currently have available to you.
Once you have your list together, do the following to calculate your credit utilization:
- Add up the balances you currently owe.
- Then add up the credit limits for all your revolving credit accounts.
- Divide the balance you owe by your credit limit total.
- Multiply that number by 100 and voila! That’s your credit utilization percentage.
Here’s what’s this process looks like with actual numbers:
Let’s say you have two credit cards. you owe $275 on one and $225 on the other, so you owe $500 in total.
If your first credit card has a $2,000 limit and the second has an $8,000 limit, then you have a total of $10,000 in revolving credit available to you.
So your utilization is $500/$10,000. To find out your credit utilization percentage, you divide 500 by 10,000, which is 0.05. Multiply that by 100, and you have your answer: 5%.
The best part is you can check your credit utilization on your own any time you want.
What’s a Good Credit Utilization Ratio?
According to credit reporting agency Experian, a credit utilization ratio below 30% is generally recommended for scoring well on popular credit scoring models like FICO and VantageScore.
However, it’s even better to aim for a ratio as close to zero as possible. Ideally, you should strive to pay off your balances in full each month.
If that’s not feasible, keeping your credit card balances below 30% of your available credit limit demonstrates responsible credit management.
How to establish your best credit utilization ratio
To achieve a credit utilization ratio of 30% or less, consider implementing the following strategies:
Option #1: Pay Down Your Debt
The most straightforward approach to decreasing your credit utilization ratio is to reduce the amount of credit you utilize. While this may be challenging, employing debt repayment strategies like the debt snowball or debt avalanche methods can help you gain traction in your journey towards financial freedom.
- Debt Snowball Method: Start by paying off the smallest debt balance while making minimum payments on other accounts. As you eliminate each debt, move on to the next, creating momentum.
- Debt Avalanche Method: Prioritize paying off debts with the highest interest rates first, while maintaining minimum payments on the rest. Though it might take longer to eliminate high-interest debts, this method minimizes interest incurred over time.
By adopting either method, you’ll gradually reduce your debt, which, in turn, will positively impact your credit utilization ratio.
Option #2: Increase Your Credit Limits
Increasing your credit limits can effectively improve your credit utilization ratio. Although it may seem counterintuitive when trying to pay off debt, raising your credit limits automatically decreases your credit utilization percentage.
Suppose you have a credit card with a $500 balance and a $1,000 limit, resulting in a 50% utilization ratio. By increasing your credit limit to, let’s say, $5,000 while maintaining the same $500 balance, you instantly drop your utilization ratio to 10%.
However, remember not to increase your credit limits and simultaneously accumulate additional debt. The key is to maintain a low balance relative to your extended credit limits.
Option #3: A Combination of Debt Repayment and Credit Limit Increase
To maximize the impact on your credit utilization ratio, consider implementing both option #1 and option #2. By paying down your debt while strategically increasing your credit limits, you can significantly reduce your utilization ratio. Not only will this improve your credit score, but it will also reduce the amount of money lost to high-interest rates.
Lenders prefer borrowers who manage credit responsibly. Maintaining a credit utilization ratio below 30% demonstrates that you can use credit responsibly and pay off your debts. By keeping your balances manageable and utilizing credit smartly, you increase your attractiveness to potential lenders.
Conclusion
Mastering your credit utilization ratio is vital when it comes to securing loans and maintaining a strong credit score.
By understanding the concept, calculating the ratio, and employing effective strategies such as debt repayment and credit limit optimization, you can take control of your financial situation.
