Having a very good or excellent credit score can increase your chances of getting the best interest rates and approvals for higher tier credit products. However, many people may be jeopardizing their credit rating by not considering one crucial detail—their credit utilization ratio.
Lenders may see you as a greater risk if you use a large portion of your credit limit each month, even if you pay your balance in full and never max out your credit card. Using a fraction of your credit limit can increase your credit score and show lenders you are a responsible borrower.
Your credit utilization ratio, also known as the debt-to-credit ratio, is the amount of credit you use (debt) against your total overall limit (credit).
Concerning your credit score, it is the second-largest factor in the calculation, accounting for 30% of your rating. The top aspect is your payment history, which accounts for 35% of your score and shows lenders how you manage your accounts.
It can be helpful to follow a few simple guidelines, considering the impact your credit utilization ratio can have on your credit score. Whether you have access to a small or a large credit limit, you should be mindful of how much credit you are using. Credit bureaus like Equifax and TransUnion recommend staying within a low debt-to-credit ratio, generally below 30%.
There is a simple calculation you can follow to see if your credit usage falls within this safe zone.
Before you can calculate your credit utilization ratio, you will need to determine your overall credit limit and your credit usage.
First, you will need to total the limits of all your revolving credit products. Revolving or recurring credit includes your credit cards, lines of credit, and other credit products where you can borrow, repay and borrow again.
This calculation does not include your mortgage, which is considered an installment loan.
Next, you’ll need to add up how much you spend and the balances your carry (if any) across your revolving credit products each month.
Divide your credit usage by your overall credit limit and multiply that number by 100 to find your ratio.
For example, if you have two credit cards, one with a $5,000 limit and another with a $2,000 limit, and a credit line of $5,000, you have $12,000 in available credit.
Here is a table showing how the credit utilization ratio varies by how much credit you are using.
You can also multiply your overall credit limit by 30% to get your credit utilization safe zone.
In this case, we can multiply $12,000 x 0.30 = $3,600. You would ideally spend less than $3,600 across all your credit products—the two credit cards and the line of credit.
Those who have small credit limits may find it challenging to stay below that 30% mark. Someone who has a $500 credit limit would ideally have less than $150 on their credit card at any given time.
There are a few ways you can improve your credit utilization ratio and, in turn, increase your credit score.
In an ideal world, you would pay your balance off in full at the end of each month and not incur interest. However, this scenario isn’t always possible. But, if you can, paying down your balance will lower your credit usage and hopefully get your credit utilization into that safe zone (below 30%).
If you are using your credit responsibly, you may have the option to increase your credit limit. If you typically spend the same amount each month, then you would lower your credit utilization ratio.
If you feel that you can manage a larger credit limit, this may be a great option.
Similarly, if you have a credit card with a lower limit, opening a new credit card can add more wiggle room to that overall credit limit.
For example, if you have a card with a $500 limit and you open a new account with a $2,000 limit, you would have $2,500 in overall credit. Before opening the new account, you would ideally spend less than $150 on the card.
After opening the second credit card, you could spend roughly $750 across both accounts and stay within the 30% credit utilization ratio.
Lastly, you’ll want to think twice about closing revolving credit accounts. This decision will not only affect the credit history portion of your credit score, but it will also lower your overall credit limit.
If you spend roughly 30% of your credit limit each month and close an account, it will increase your ratio and mean you are spending more than the recommended amount.
The key to building a healthy credit score is to shape your debt management and borrowing behaviours. Be mindful of your credit utilization ratio when you are making larger purchases and when considering closing accounts.
As you change your spending habits or encounter lifestyle changes, recalculate your overall credit limit and usage to stay on track. Consciously thinking about your credit utilization ratio can help improve and maintain your credit score.