How Credit Utilization Ratio Affects Your Credit Score
By Kevin Mercadante
You may be vaguely aware of what a credit utilization ratio is, but it’s actually important to know exactly what it is, because it’s a credit factor that is used by all 3 major credit bureaus. And next to your payment history, it’s the single biggest factor affecting your credit score.
What is a Credit Utilization Ratio?
Loosely speaking, credit utilization ratio is a measure of how much debt you have outstanding. However, it’s not the dollar amount. Rather, it is a percentage, based on the total amount of money that you owe, divided by total amount of credit lines you have available.
For example, let’s say that you have $25,000 in total credit lines available. You owe $10,000 on those lines. Your credit utilization ratio will be calculated by dividing $10,000 by $25,000, which will give you a ratio of 40%.
This ratio primarily applies to revolving accounts, such as credit cards and home equity lines of credit. But it also takes into consideration the total number of credit lines that you have that have outstanding balances. The more that you have, the worse it is for your credit score.
This is how all 3 major credit bureaus calculate credit utilization ratio.
How Much Impact Does My Credit Utilization Ratio have on My Credit Score
Under the current FICO scoring model, credit utilization ratio represents 30% of your credit score according to all 3 major credit bureaus. Only your payment history, at 35%, has greater importance in calculating your credit score.
Credit scoring models have determined that a high credit utilization ratio is a major predictor of loan default, which is why it has such a strong impact. For example, if you’re close to being maxed out on your credit lines, you’ll have little or no available credit, and may have no alternative to default in the event of a job loss.
What’s a Good Credit Utilization Ratio?
The 3 major credit bureaus are somewhat ambiguous on this point. Generally speaking, a credit utilization ratio of 30% or less, is considered favorable. To the degree that you exceed this ratio, it will have a negative impact on your credit score.
The weight of the ratio will actually become even greater if it moves toward 100%. Under certain circumstances, it may be possible that you have a credit score that is in the poor or fair range, even though you have no derogatory credit whatsoever.
How to Improve Your Credit Utilization Ratio
The obvious way to improve your ratio is to pay down your debts. That doesn’t mean you have to drop your ratio down to 30% or less, but you should generally move in that direction. For example, lowering the ratio from 70% to 50% should result in a significant improvement in your credit score. As well, paying off some of your credit lines should also help, since it will leave you with more credit lines to tap in the event of an emergency.
There’s an important point in this regard too. When you pay off a credit line, it’s best to not close it out. A closed credit line reduces your total available credit, and can actually have the effect of increasing your credit utilization ratio. It’s best to payoff the credit line, but leave the line available.
Using Good Credit Report Service to Track Your Credit Utilization Ratio
In order to effectively track your credit utilization ratio - and to improve it - you’ll need a really good credit report service, one that provides you with access to your credit report, as well as credit scores from all 3 major credit bureaus. This will be the only way to really track the progress of your efforts to improve this all-important ratio.
Still confused about how a score is calculated? Our helpful infographic will help break down the credit score confusion.
About Kevin Mercadante
Kevin Mercadante is a freelance professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has extensive backgrounds in both accounting and the mortgage industry. Follow Kevin on Google+.