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What is a Credit Utilization Ratio?
You have a credit card. Let’s say it has a credit limit of $5,000. You buy things with the credit card. Now you have a balance of $2,000 on that card, leaving $3,000 still available for spending.
The amount you’ve spent – or utilized – on that card divided by how much credit you have is the credit utilization ratio.
If you have spent $2,000 out of a possible $5,000, your credit utilization ration is $2,000 divided by $5,000, or 40%. If you run up a balance of $2,500 on that $5,000 card, your credit utilization ratio is 50%, or half. You’ve spent half of your available credit.
Your credit utilization ratio is simply a mathematical equation. Why does it matter? After all, you still have thousands available on your credit card to spend. Banks and more importantly – credit bureaus – care about that credit utilization ratio quite a bit.
Why Utilization Ratios Matter
Why do we bother calculating your utilization ratio? Because it paints a picture of how you are using your revolving credit, and that affects your credit score. Remember that your credit score is a measure of how well you use credit. Credit utilization ratio weighs heavily on the score – up to 30 percent of your total score.
You can make every single payment on time, but if you are carrying high balances on all your credit cards, your FICO score isn’t going to go much above a fair credit score. High balances, minimum payments plus a late payment or two will send your score back into the realm
of bad credit.
Why? In short – high credit card balances make banks nervous.
RELATED: What’s Your Debt-to-Income Ratio?
If you’ve maxed out your credit cards and you’re making only the minimum payments, you don’t have much wiggle room in your budgeting and personal finances. One missed paycheck could spell disaster. This is why high credit utilization ratios are punished by the credit bureaus.
Using credit wisely means not carrying balances on your cards. A perfect credit card user charges on his or her card for convenience and then pays the balance off every month when the bill comes. FICO scores reflect this preference.
The lower your credit utilization rate, the higher your credit score will be. 30% is the magic number. If your utilization ratio is below 30%, you won’t be penalized. Over 30% and banks feel you have too much debt.
Improve My Credit Utilization Ratio
Lowering your credit utilization ratio is one of the best ways to boost a poor credit score or to take a fair or good credit score into a better category.
The better your credit score, the easier it is to get loan approvals. You’ll also see far better terms on the loans you are approved for. Individuals with very good or excellent credit – a score over 740 – enjoy excellent promotional offers and ultra-low interest rates.
Fortunately, you can improve your credit utilization ratio almost overnight. The utilization ratio reflects only your revolving debt, or credit cards. Paying off your credit cards takes your credit utilization ratio to zero or close to it. You can pay off the balances on all of your credit cards
in a single move using personal loans for debt consolidation.
Personal loans are an unsecured loan, like a credit card, but they aren’t revolving debt. A personal loan will have a set number of payments over a set amount of time. Make all the payments and the loan is done, much like a car loan.
Fix payment loans, like a car loan or personal loan, aren’t considered as part of your credit utilization ratio. That means that taking out a large personal loan and using that loan to pay off all of your credit card balances, wipes out all of your high utilization numbers.
You still have the debt, of course, but it is now in the personal loan. You may find that the fixed payments of the personal loan are smaller than the combined minimum payments on the various credit cards you paid off, making it easier to work the new loan payment into your budgeting plan.
RELATED: How Do Credit Utilization Ratio and Debt-to-Income Ratio Affect My Credit Score?
Two warnings about using a personal loan for debt consolidation.
- Don’t charge the cards back up but leave them open. Having a zero balance on a credit card is a
great thing, but it can be tempting to have available credit just sitting there. If you start charging
new purchases on the newly cleared cards, you will wind up with twice the debt and a lowered
- Move quickly when you apply for a personal loan. Each new loan application results in a credit
check. Too many hard inquiries will lower your credit score. This is a temporary dip, but
shopping for a good interest rate over.
Credit utilization is only one piece of the larger puzzle that makes up a credit score. Timely payments is another huge factor, and other things weigh in, including how many credit cards you have, how long you’ve had them and how many cards you’ve applied for in the last six months.
Credit utilization is also one of the easiest things to improve in your credit score because it often can happen in less than a week – apply for a personal loan, pay off your balances, and enjoy the benefits of a lower monthly payment and higher credit score.