Credit utilization ratio – a significant factor in your credit score
Most consumers who keep a close eye on their credit score know exactly what a credit utilization ratio is; it’s the percentage of your total credit limits that you actually use.
A balance of $1000, with a $5000 total credit limit on all revolving accounts, equals a 20% credit utilization ratio.
A low credit utilization ratio is good for your credit score; it’s recommended to keep it under about 30% of your total credit limits, and less than that is even better.
Your credit score will suffer if you use too much of your available credit; thirty percent of your credit score is based on your credit utilization ratio. Maxed-out credit cards will wreak havoc on your credit score.
It’s important to be aware of how your credit utilization ratio affects your credit score at any given time, especially if you plan on applying for credit in the near future, such as a home mortgage or car loan, or even a credit card.
A better credit score saves you money in the form of better interest rates and more generous benefits from your lender or creditor.
Responsible credit card users’ credit score may not truly reflect their credit habits.
The funny thing about credit utilization is that it simply shows how much you use your credit cards. But it doesn’t really say anything about how well you can afford to pay your debts.
Credit cards are no longer used strictly for emergencies like they used to be, and using a credit card doesn’t mean that you don’t have the money in the bank.
Many use credit cards daily for the convenience of it; swiping a credit card is so much quicker than pulling out cash and waiting for change. In our fast-paced society, those few extra seconds can make a difference in our day.
And the rewards are another reason many responsible consumers choose to use their credit card for monthly bills and daily purchases, when they could just as easily use a debit card for the same convenience.
Smart credit card users know how to get free use of somebody else’s money every month, by using their credit card and then paying the full balance before finance charges are assessed.
But using a credit card for most purchases brings up your credit utilization ratio, especially if your credit limits aren’t much higher than the amount of credit you actually use each month.
For example, you may consistently put $2000 on your $3000 limit card every month. You never put more on your card than you can pay off each month, and you may not see the need to apply for additional credit cards or a credit limit increase because you believe you will never need more credit at your disposal.
This would seem like the habits of a smart, responsible borrower. But that kind of usage would put your credit utilization ratio at 66%, something that make creditors nervous and damages your credit score.
And keep in mind your credit utilization ratio is not a fixed number; it can change dramatically over the course of one month, depending on when you pay your bill and when the creditor reports your payment and balance to the credit bureau.
Paying your full balance each month would put you at a zero percent ratio immediately after the creditor receives the payment; that should be good for your credit score.
But what if your creditor reports your balance just before you make the full payment? Your credit score will suffer for it, no matter how good of a grip you have on your finances.
A borrower with a low credit utilization ratio may still be in over their head in debt.
A credit limit increase is normally considered to be a good thing. It shows that you’ve been good at handling your debt with on-time payments, and that the creditor trusts you enough to let you loose with more available credit.
It also brings your credit utilization ratio down, as long as you don’t increase your debt load. A lower credit utilization ratio means a higher credit score, and a higher credit score means that you’re financially in good shape, right? Well, not always.
The higher credit limits probably won’t present a problem for those who are careful about how they use credit. Having more credit available doesn’t mean you have to use it, and financially responsible consumers will control their spending, no matter what their credit limits are. These consumers can enjoy the privelege of a higher credit score, and the better financing deals that go with it.
But let’s just say we have someone who has managed their debts well in the past, and they have several credit cards with a total credit limit of $10,000. They carry a balance of $2000, and their monthly payments rarely exceed the amount of the interest charges and new purchases each month.
So the $2000 balance is pretty consistant from month to month. With a 20% credit utilization ratio and a good credit score, creditors may eventually decide to increase their total limits to $15,000.
Some consumers in this situtation will spend a little more than usual when they get their credit limit increase. With higher credit limits at their disposal, they can let their balances grow to $3000, while still maintaining a low 20% credit utilization ratio.
A 20% ratio may be great for a credit score, but $3000 is a lot of credit card debt to carry around if you can’t afford to pay it off every month, or at least within a few months. A low credit utilization ratio can give consumers the illusion of a manageable level of debt. In reality, the debt may be more than the consumer can afford to get ahead of within a reasonable amount of time.
The worst-case scenario is when a troubled borrower routinely requests credit limit increases in order to keep a good credit score, while maintaining their otherwise out-of-reach lifestyle. Credit limits keep increasing while the debt keeps growing, until the day the borrower realizes they’ve let their spending get out of hand.
It may eventually become difficult for them to even make the minimum payments on thousands of dollars worth of credit card debt. From there, their credit scores and financial health can be damaged pretty badly.
Be smart in handling your debt.
So, even though your credit score is important for you to get additional financing, it’s important to ensure that the dollar-amount of your debt remains at a manageable level.
Someone with a relatively low credit score may own more than they owe and have plenty of money in the bank, while someone with a higher score is barely scraping by and living off of their credit cards. A credit score has much to do with the financing that’s available to you, but it really has nothing to do with your overall financial picture.
A good credit score is still important. It’s what makes homeownership and buying a nice car possible. It’s what get you better deals on credit cards and lines of credit.
A good credit score will make it easier to attain the things we need and want, but having a good credit score, in itself, won’t improve your financial situation; it only means that it’s easier to borrow money.
Understand where your credit fits into your overall financial picture, and make decisions to improve your financial health, not just your credit score. With careful planning and responsible spending, someday, you may not ever have to borrow money again.