Wise use of credit can have a powerful impact on your finances. It helps you stay within your means and enables you to receive the best interest rates when you need a loan. However, using too much of your available credit may betray your financial goals. When you do, you may get your credit utilization ratio out of balance. Lenders use that as a key factor in their decision-making process to determine whether or not to extend you a new line of credit.
What is a credit utilization ratio?
How you use your credit card says a lot to lenders. One key thing they watch is your credit utilization rate. This refers to how much of your available revolving credit you use each month.
This doesn’t include mortgages, auto loans, or personal loan debt; just credit. Each individual card has a rate, and you have a total rate across all of your cards. A lower percentage is typically better and makes you less of a risk to lenders, as it generally reveals that you manage your finances well.
How to calculate your credit utilization ratio
It’s not difficult to determine your number. To calculate your credit card usage percentage, divide how much you owe on a revolving basis by your total available credit.
For example, let’s say you have three credit cards.
- Card 1 – $10,000 limit with $3,000 balance
- Card 2 – $5,000 limit with $2,000 balance
- Card 3 – $5,000 limit with $1,000 balance
You have a combined $20,000 in available credit and $6,000 in balances. This gives you a utilization rate of 30%. You can also use a credit utilization ratio calculator to determine your rate.
What is a good credit utilization ratio?
Carrying a lot of consumer debt is typically not a sign of financial responsibility, especially in the eyes of potential creditors. If you want to determine how much of your credit line you should use, the answer is fairly straightforward.
Most experts recommend that you use no more than 30% of your available credit. This applies to both individual accounts and your cumulative amount.
While delinquencies are increasing across America, more than half of Americans are using less than 20% of available credit as of the first quarter or 2024, according to the Federal Reserve Bank of New York.
Having a lower percentage typically means you have a better credit score. Furthermore, better scores often result in more competitive interest rates if you need a mortgage or car loan. If you want to maximize your efforts, it’s advisable to keep usage to under 10% of your available credit.
That may lead you to think that having a 0% ratio is best. That’s not necessarily the case. Lenders want to see you know how to use credit cards sensibly, not that you use as little as possible. So, if you use your cards for most purchases but pay them off in full each month, you will likely stand out to lenders as someone who does not abuse credit cards.
Why does a high credit utilization decrease your credit score?
How much you use of your available credit limit is something to take seriously. While it’s not always easy to determine what percentage of credit card debt gives a good credit score, your ratio is the second most important factor of your FICO Score. The credit utilization rate makes up 30% of your total score. Only payment history is more important, making up 35% of your overall credit score.
If you consistently use too much of your available credit or carry debt, you present too much risk in the eyes of lenders. They may view your habits as reckless and believe you use credit cards too often to finance purchases you can’t afford.
If you plan on applying for a new loan or credit card in the near term, it’s best to improve your ratio as that can help put your application in a better light.
How to improve your credit utilization ratio
The quickest and most effective way to reduce your credit utilization is to reduce debt on your credit cards. It’s best to analyze each card and your aggregate situation. Actively work to lower the debt utilization ratio on each, and cumulatively to under 30%.
Doing so will help reduce the total usage rate the next time it’s calculated, which FICO usually updates monthly. Here are some other legitimate ways to lower your credit utilization ratio:
- Ask for a credit limit increase: Do you have a positive history and relationship with your credit card company? You may want to ask them to increase your credit limit. This will help increase your available credit without adding debt. Just make sure you’re not carrying a lot of debt on the card, and always pay on time before asking.
- Don’t close old credit cards: It can be tempting to close an old card, but it could hurt you. Length of credit history is the third most important factor in your credit score, at 15%. Additionally, closing an old credit card will reduce your available credit, potentially impacting your ratio.
- Decrease spending: Like paying down credit card debt, work to decrease spending. Use your credit cards as tools to manage your budget instead of to fund frivolous purchases, and your ratio will steadily improve.
- Get a debt consolidation loan: If you’re in debt and are serious about making progress, a debt consolidation loan may be a wise move. This moves your debt from revolving to installment, allowing your ratio to increase. Do your due diligence before making this move to ensure it makes wise financial sense. A balance transfer credit card might be a suitable alternative.
The bottom line
Having a healthy credit utilization ratio is a key component of a good credit score. It’s easy to calculate your rate with a calculator, or you can consult your credit report to see what’s currently reported. By following prudent spending habits and reducing your revolving indebtedness, you can increase your chances for success on your next card application or loan request.
