Your credit score is one of the most important numbers in your life. It affects whether you’re approved for a loan or credit card. Credit scores also determine how much interest you’ll pay when you borrow money for anything from a house to a car.
Plus, landlords and even employers often access your credit report to determine how reliable a tenant or employee you might be.
Keeping your FICO score as high as possible is a big deal. Your credit scores can range from 300 to 850. Anything higher than a 700 is considered “good,” while the “bad” credit range is anything under 600.
How Credit Scores Are Calculated
There are five different categories used to calculate your credit scores, each one with a different ranking of importance. Here’s how each category of credit affects your credit score:
- Payment History: How frequently you pay your bills on time accounts for 35% of your credit score.
- Credit Utilization: The amount of debt you owe to creditors and lenders makes up 30% of your credit score.
- Length of Credit History: How long you’ve had access to credit is worth 15% of your credit score.
- Credit Mix and Inquiries: The diversity of the types of credit you have and the number of inquiries you’ve had in the past two years each account for 10% of your credit score.
As you can see, the amount of debt you carry, or credit utilization, is the second most important component of the FICO credit scoring model. It’s the amount of money you’ve borrowed through both loans and credit cards and compares it to your actual credit limits.
How does your credit utilization ratio affect your credit score?
Credit utilization takes into account the following:
- How much debt you still owe.
- How many actual accounts have debt owed on them.
- How much you owe on each account.
- The percentage of revolving credit lines.
- The percentage of installment loan debt.
- The lack of certain kinds of loans.
All of these items combine to contribute nearly one-third of your FICO score. So if you want to improve your credit scores, you’re going to want a low credit utilization ratio.
How to Calculate Your Credit Utilization Rate
When calculating your credit scores, one of the most significant factors is how much credit you’re using on revolving accounts compared to your total available credit.
This is referred to as your credit utilization ratio or credit utilization rate. (Also referred to as balance-to-limit ratio or debt-to-credit ratio.) Your credit utilization ratio is a very simple calculation to figure out.
To calculate your credit utilization ratio start by tallying up all of your debts, then separately tabulate all of your credit limits. Then, divide the amount of debt by the total credit limits, and that’s how you calculate your credit utilization ratio.
So if you have two credit cards with a combined credit limit of $5,000 and you owe $1,000, your calculation would be 1,000 / 5,000. You get 0.20, which means your overall credit utilization ratio in this scenario is 20%.
It’s calculated using all of your debts spread out across all of your spending limits.
Revolving Debt vs. Installment Debt
Credit scoring models also factor in the different types of debt you might have on your credit report. For example, revolving credit accounts like credit cards and store cards are weighed more negatively than installment loans such as mortgages, student loans, and auto loans.
There are a few different reasons for this. One is that installment loans like those on your house and car have collateral attached to them.
If you stop making payments, the lender can foreclose on the home or repossess the car. That makes people more likely to repay those loans before any other type of debt. It also helps the lender recoup the loss of the loan payments.
Student loans don’t have collateral. However, they do indicate to lenders that you might have a higher capacity for earning potential over time. On the other hand, revolving debt from credit cards has no collateral attached to it.
What Lenders Look At
Lenders believe you’d be less likely to pay on it if you came into financial hardship because you have nothing to lose (except your good credit score). Installment loans like mortgages and student loans are typically viewed as “good debt” because they can add value to your income and net worth.
So, when your credit score is calculated, it takes into account not just how much debt you have but what kind of debt you have. This knowledge can help you focus on your goals if and when you decide to pay off your debts aggressively.
It’s best to start with anything owed on a credit card or retail card because they typically carry higher interest rates. They also are weighted more heavily when your credit utilization rate is calculated for your credit score.
What is a good credit utilization ratio?
So now you have the information you need to figure out your credit utilization ratio. How does it look? Most financial experts recommend owing no more than 30% of your credit limit. So if your total credit card limits are $5,000, you wouldn’t want to owe more than $1,500.
Of course, if you pay off your balance in full each month, it’s OK to charge that amount. However, when applying for a loan or credit card, it may show your average balance even if you pay it off regularly.
5 Ways to Lower Your Credit Utilization Ratio
1. Credit Card Usage
To get around this technicality, you could stop using your credit cards for at least a month before submitting a financing application. You could also spread out your purchases to multiple credit cards. Or you can pay on your account multiple times a month, so the balance never looks too high.
The key is to make sure your balance is low by the end of your billing cycle. Another thing you may want to do is find out when your credit card issuer reports information to the credit bureaus. Make sure your credit card balances are low when they are being reported.
2. Increase Your Credit Limit
Call your credit card issuer and ask for a credit limit increase. This is one of the quickest and easiest ways to lower your credit utilization ratio.
3. Keep Credit Accounts Open
When you pay off a credit card, should you automatically close the account?
No. Closing your credit card account removes some of your total available credit and increases your credit utilization ratio. This is the opposite of what you want to do. Here’s how that happens.
Let’s go back to the example where you owe $1,000 and have $5,000 in total available credit. Say each credit card has a credit limit of $2,500, but you have a credit card balance of $1,000 on just one card. If you close the balance-free card, your total credit limit drops to $2,500.
Instead of having a 20% credit utilization ratio, the new calculation shows that it has instead jumped up to 40%. That’s double your initial credit utilization rate! Once that happens, your credit scores will inevitably drop.
4. Pay Off Credit Card Debt
The most obvious way to lower your credit utilization ratio is to pay off your credit card balances and other debt as aggressively as possible. This will increase your credit score in various categories, especially in the “Amounts Owed” category.
Remember the subcategories of credit utilization. Credit scores take into account your overall credit utilization rate, but also your rate for each account.
So, if you’ve maxed out one card and don’t have much charged on the others, focus on getting the high balance card paid down first. If you want to increase your credit score quickly, this is the best method for paying off credit card debt.
5. Open a New Line of Credit
Another way to lower your credit utilization ratio without paying down extra debt is to open up a new credit card account. You’ll automatically have a higher overall credit limit by adding a new credit card.
Of course, each hard inquiry for a new credit card or loan application has the potential to temporarily lower your credit score between 5 and 10 points. So be careful how often you do this.
If you already have a lot of inquiries on your credit report, this may not be looked on favorably by lenders. However, if you haven’t had any hard inquiries in the past two years, you may want to get another credit card. If you use it responsibly (or not at all), it could positively affect your credit scores.
One last red flag lenders look for on a credit report is when you have too many balances spread across several cards. Yes, your per-card credit utilization rate appears lower. Still, if you make frequent charges on multiple credit cards, it can be problematic for an underwriter reviewing your loan or credit card application.
Another strategy to address this issue is to pay down the smallest card first so that you clear an entire credit line quickly.
Figuring out how to lower your credit utilization ratio may seem daunting at first. But, regardless of what the technicalities may be, simply paying down your debt is often the best way to improve your credit scores.