Building and maintaining an excellent credit score should be a top priority for every adult. A good score can create opportunities and generate significant financial savings in our world where loans and credit are commonplace. Everyone from lenders, landlords, and even some employers use your score to gauge your financial trustworthiness.
While many factors go into determining your credit score, a quick and simple way to gauge your creditworthiness is through your credit utilization ratio. Lenders use this figure to measure how much risk is involved when lending you money – ultimately, it plays a role in how much you’ll pay to borrow those funds.
What is a Credit Utilization Ratio?
Your credit score gives lenders a snapshot of how well you manage credit. Five main components make up your score, and each holds a different weight or value.
- Payment History (35%)
- Amount Owed (30%)
- Length of History (15%)
- Credit Mix (10%)
- New Credit (10%)
Your credit utilization ratio, or CUR, falls into the “Amount Owed” portion of your credit score. This ratio displays the amount of credit you’re using from your total available credit. In short, it allows lenders to see how well you manage revolving credit, such as credit cards, home equity lines of credit, and some personal loans.
How is a Credit Utilization Ratio Calculated?
To determine your CUR, you will need your current credit card balance(s) and the credit limit amount for each credit card. Then, you will divide your outstanding balances by your total credit limit and multiply it by 100 to get a percentage.
Credit Utilization Ratio = Total Outstanding Credit Card Balances / Total Credit Limit x 100
Example:
Imagine you have three credit cards with the following balances and credit limits:
Outstanding Balance | Credit Limit | |
Credit Card A | $450 | $1,500 |
Credit Card B | $750 | $2,000 |
Credit Card C | $1,000 | $3,250 |
In this example, your total outstanding balance is $2,200, and your total available credit or credit limit is $6,750. As a result, your credit utilization ratio is 32.6% ($2,200 / $6,750 x 100).
Lenders prefer CURs to be below 30%. People with excellent credit scores typically have a CUR below 7%.
Why Does a Credit Utilization Ratio Matter?
Your credit utilization ratio lets lenders quickly assess how well you manage revolving credit. While there are various types of revolving credit, credit cards are by far the most popular. Lenders want to see that you can responsibly manage the funds made available to you, and your CUR is typically one of the first figures they will review.
For example, if you have one or more credit cards nearly maxed out, that can be a sign to a lender that you’re in financial trouble and a greater risk. A higher credit utilization ratio will also reduce your credit score, resulting in higher interest rates and more expensive loans.
On the other hand, if you have a low CUR, lenders will be more likely to extend new credit to you and make it more affordable since they view you as a lower risk.
How to Reduce Your Credit Utilization Ratio:
Two components comprise your CUR: your outstanding balances and total credit limit. To reduce your credit utilization ratio, you can either reduce your outstanding debt or increase your credit limit.
- Reducing Outstanding Balances:
Paying off your outstanding debt is the best and most responsible way to improve your CUR. As your balances decrease, your CUR will likewise fall. This strategy also demonstrates to lenders that you’re actively managing your debt.
Example:
To illustrate how reducing your outstanding balances will impact your CUR, let’s revisit the example from earlier. Assume you reduce each balance by $150.
Outstanding Balance | New Balance | Credit Limit | |
Credit Card A | $450 | $300 | $1,500 |
Credit Card B | $750 | $600 | $2,000 |
Credit Card C | $1,000 | $850 | $3,250 |
Paying $150 toward each credit card drops your current outstanding balance to $1,750. Originally your CUR was 32.6%. Now, it is 25.9% - below the ideal 30% threshold.
- Increasing Your Credit Limit:
Another option is to increase your credit limit(s). This strategy should only be used if you already have a good credit score, manage debt responsibly, and are looking to boost your score. The additional credit limit is meant to bump your score – not to be spent. If you can avoid the temptation to spend more on your card, this could be a good tactic to try.
If you have credit cards nearly maxed out, raising the limits tends to lead to more financial problems. Giving yourself access to more credit when you’re already at your limit can lead to temptation and more debt.
To raise your credit limits, you must contact your credit card company and request a limit increase. Whether the increase is granted is up to the card issuer.
Example:
Using the example from earlier, imagine each credit card company increases your credit limit by $500.
Outstanding Balance | Credit Limit | New Credit Limit | |
Credit Card A | $450 | $1,500 | $2,000 |
Credit Card B | $750 | $2,000 | $2,500 |
Credit Card C | $1,000 | $3,250 | $3,750 |
With the new, higher credit limits, your CUR drops from 32.6% to 26.7% – below the preferred 30% benchmark.
We’re Here to Help!
An excellent credit score can significantly reduce how much interest you pay on loans. Your credit utilization ratio provides a glimpse into how well you manage revolving credit. If you’re not below the 30% threshold, make it a goal to reduce your balances until you hit the mark.
If you’re interested in learning how debt consolidation can help you pay off outstanding credit card balances quicker, we’re ready to help. Please give us a call today to speak with a team member.
