Credit Utilization: What it is and how it can affect your credit score?

Taking an active interest in upping your financial knowledge is a great way to invest in your own financial future and gain more confidence in your decisions. Let's explore an important financial concept together: credit utilization.

Credit utilization is an important credit score factor. It’s also a measure of financial health. 

What is credit utilization?

Credit utilization is the percentage of your available credit that you're currently using on your revolving credit accounts (credit cards). It’s the amount you owe compared to your credit limits.

For example, if you have a credit card with a $1,000 credit limit, and your balance is $400, you’re using 40% of your available credit. In other words, your utilization ratio is 40%.

Credit utilization affects credit scores because it measures how close you are to maxing out your credit. Using up most or all of your available credit could signal to lenders that you’re financially stressed. People with higher credit card balances are statistically more likely to default on their debts. 

Credit utilization is calculated for each credit card and overall. It includes any outstanding balances on credit card accounts you’ve closed, and unsecured personal lines of credit. However, it doesn't include installment loans or home equity lines of credit.

How credit utilization affects your credit score

The higher your credit utilization ratio, the more likely it is to have a negative impact on your credit score. 

A low credit utilization ratio shows that you have access to credit but manage it well, avoiding excessive debt. A high utilization ratio could mean that you can’t afford to get yourself out of debt.

According to FICO, these are the factors that influence your credit scores:

• Payment history (35%)

• Amounts owed (including your utilization ratio) (30%)

• Average account age (15%)

• Credit mix (whether you have experience with different kinds of credit accounts) (10%)

• Inquiries (how often you apply for new credit) (10%)

Utilization is a key component of the “amounts owed” category. Having even one maxed out credit card could significantly hurt your credit standing, even if you make your monthly payments on time. 

Since credit utilization is one of the most important credit score factors, managing it is a key to improving your credit. 

What is a good credit utilization ratio?

There’s no absolute cut-off between a bad and good credit utilization ratio. It’s more of a sliding scale. The lower you can get your credit utilization, the better.

If your cards are maxed out, it’s important to stop using them and start chipping away at the balance. A 90% utilization is still likely to have a negative impact on your credit score, but it’s better than 100% (a maxed out card). And 80% is better than 90%.

If a top credit score is your goal, you’ll want to shoot for a utilization ratio under 10%. 

What’s considered a bad credit utilization?

As noted above, there is no absolute number for what is considered bad or good credit utilization. It’s a scale from 0% to 100%. For calculating credit score, 0% is ideal and 100% is a warning sign. You might start to see a negative impact on your credit score once your utilization goes above 30% or 40%. Conversely, you might see a positive impact as you bring those balances down.

Freedom Debt Relief is not a Credit Repair Organization and does not provide, or offer, services or advice to repair, modify, or improve your credit. 

Improving credit isn’t the only reason to work on lowering your credit utilization. Lowering your credit utilization is a great way to save money on interest charges and put yourself in a position to work toward other financial goals.  Also, maxing out your credit cards limits your financial flexibility. It leaves you with less credit available to deal with an emergency or opportunity. 

How to calculate your credit utilization

It’s fairly easy to calculate credit utilization ratios. Here’s a worksheet you can use:

Instructions to Calculate

1. Enter your current balance - for each credit card in the "Current Balance" column.

2. Enter your credit limit - for each card in the "Credit Limit" column.

3. Divide the current balance by the credit limit - for each card.

4. Multiply the result by 100 - to get the credit utilization percentage and enter it in the "Utilization %" column.

If you have more than four credit cards, you can make a larger worksheet on a piece of paper, or use a spreadsheet program. You also may be able to find your credit utilization ratio on websites that offer free credit scores.

Why credit utilization matters for debt relief seekers

A high credit utilization ratio is a sign of financial stress. A large credit card balance is a very expensive form of debt. 

Too high a credit utilization ratio also means you’re getting close to the financial edge. As that ratio gets larger, you have less room to continue borrowing. You could soon reach the point of not being able to afford your life.

If you’re having trouble getting your credit utilization down, you may want to consider debt relief. Debt relief can help you lower your credit utilization in a variety of ways:

• Debt consolidation means taking a loan and using it to pay off more than one smaller debt. It might be a smart move if you can qualify for a lower interest rate or a lower monthly payment. 

• Credit counseling can help you figure out how to create a workable budget.

• If you genuinely can’t afford to fully repay your debts, you could negotiate with your credits. Debt settlement means getting your creditors to agree to take a lesser amount but consider the debt cleared. If you don’t want to negotiate on your own, you can work with a professional debt settlement company. 

How to lower your credit utilization

There are two ways to lower your credit utilization: bring your balances down or get your credit limits raised. 

You can try some combination of the following steps:

• Make extra payments every chance you get. Even $5 or $10 counts. Bringing your balances down is a great way to create a better financial situation while working toward a better credit standing. 

• Timing matters. Credit card companies typically report to the credit bureaus at the end of each billing cycle. Your credit card could look maxed out if your balance is reported before you make a payment. If you’ve made a large charge with your card, consider making a payment before the end of the billing cycle to soften the impact on your credit utilization.

• Spread out your debt. Credit utilization is calculated for individual cards and overall. So, don’t allow too much debt to accumulate on any one card, because that might result in a very high credit utilization ratio for that card. 

• Ask for a credit limit increase. If you have a good payment history, your creditor might agree to raise your limit. If you have a $400 balance on a credit card that has a $1,000 limit, your utilization is 40%. But if the limit is $2,000, your utilization is only 20% even though the balance is the same. Just don’t use the raised limits to borrow more. This strategy only works if you have a higher limit but the same balance. Note that asking for a limit increase might result in a hard credit inquiry, which could temporarily knock a few points off your credit score 

• Consolidate your debts. If your credit is good enough to qualify, you could pay off your credit cards with a personal loan. Installment debt doesn’t affect your utilization the way credit card debt does. The key is to avoid putting new debt on the credit cards after you pay them off.  

Once you’ve started working on your credit utilization ratio, monitor it monthly to track your progress. Free credit score websites make it easy, or track your credit limits and balances by checking your monthly statements or logging into your credit card accounts online.

What’s next

Reducing credit utilization is a key to managing your credit standing. And lowering credit card debt is great for your finances.  

If your credit utilization is high, bringing it down may seem like a big task. Remember that there are several ways of doing it. That means you can handle it with a series of small steps.

So it’s okay if it doesn’t happen all at once. The idea is to take some steps towards reducing credit utilization as soon as you can. Then build on those steps to develop healthy financial habits.