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When it comes to credit scores, the more you know, the more you can build!
We usually hear about the importance of paying bills on time — and how that has the largest impact on your credit score. But something that’s not as commonly known is the power of your “amounts owed” — which determines your credit utilization. If you haven’t heard the term “credit utilization” before — we’re here to break down what you need to know.
What is credit utilization
In simple terms, credit utilization refers to the amount of credit you are using out of the total credit available to you. It’s typically calculated as a percentage of your available credit and signifies the amount of credit you owe.
The cookies analogy 🍪
Let’s say you have a jar with 10 cookies, and you eat 3 of them. That means you ate 30% of the cookies available to you.
The credit you are using would be the 3 cookies you are eating, and your total credit limit would be the jar with 10 cookies; therefore, your credit utilization would be 30%.
In summary, there are 2 specific factors that contribute to your credit utilization:
- How much credit you’re using (or cookies you’re eating)
- Your total credit limit (or total cookies in the jar)
Your credit utilization percentage is used as a marker for lenders to determine if you’re a “creditworthy” borrower. In other words, should they give you money to borrow, and, if they do, what are the chances you’ll pay it back?
Why your credit card utilization percentage matters
When looking at your credit history, your “amounts owed” makes up 30% of your credit score. This is a close second to “payment history,” which makes up 35% of your credit score.
That’s because, when considering approving or denying an application for credit, lenders use this percentage to assess their risk.
Your “amounts owed” gives lenders an idea of how dependent you are on credit. If you use a lot of the credit that is offered to you, the lender will likely consider you to be a higher risk.
🍪 For example, if you were offered that jar of 10 cookies and chose to eat them all, it might seem like you can’t be trusted with a whole jar of cookies again. But if you only ate 3 of them — even though 10 were offered to you — you appear to be less risky.
In other words, lenders want to know you have some restraint, sense of responsibility, and financial stability and that you won’t eat the whole jar of cookies in one sitting!
What is the ideal credit utilization?
So, if lenders don’t want you to “eat all of the cookies in the jar,” what’s a reasonable amount? What is a good credit utilization ratio?
A rule of thumb that credit savvy consumers go by is sticking to below 30%. So if you have a $1,000 credit limit, you would carry a balance of less than $300. If you have 10 cookies in the jar, you’re eating less than 3.
But, for even better results, you might want to use even less. According to credit bureau Experian, “People with exceptional credit scores (800 or higher on the FICO® Score range of 300 to 850) tend to keep utilization under 10% for each card and for total credit card use.”
In other words, the lower, the better when it comes to credit utilization. If you’re maxing out your credit card and paying it in full and on time, that’s great. But it won’t help your credit utilization, which still makes up 30% of your score.
How to calculate credit utilization
To calculate your credit utilization do the following:
- Add up the balances on all your credit cards
- Add up the credit limits on all your cards
- Divide the total balance by the total credit limit
- Multiply by 100 to see your credit utilization ratio as a percentage
For example, let’s imagine you have the following credit card balances and credit card limits:
|Credit card||Credit card balance||Credit card limit|
After adding up the total balance ($2,750) and the total credit limit ($6,000), you then divide $2,750 by $6,000 which gets us .46. Then multiply that number by 100 to get your credit utilization percentage, which in this case would be 46%.
How to improve credit utilization
If using too much credit — aka having a high credit utilization percentage — is affecting your credit score, and you’re working on building credit, there are a few things you can do.
- Lower your balance. This means using less of your available credit and keeping tabs of how much you owe.
- Increase your credit limit. Typically, you can do this by applying for a new credit card or seeing if you can get a limit increase on your current cards.
- Try a credit card alternative. Unlike traditional credit cards, Chime’s Credit Builder card has 0% APR and $0 in fees. Credit Builder also doesn’t report your percent of utilization to the major credit bureaus because it has no pre-set credit limit. That means spending up to the amount you added to your Credit Builder card will not show a high-utilization on your credit history.
When you apply for a new credit card, your credit score may drop slightly. That’s because there’s a “hard inquiry” — where a lender does a full check on your credit to review your creditworthiness. Luckily, it recovers pretty quickly if you use that increased limit to your advantage instead of charging more on the card. Overall, having a higher credit limit and lower balance will improve your credit utilization ratio, which is a good thing!
How does credit utilization affect your credit score?
Depending on the credit-scoring model you are using, how your credit utilization will affect your credit score will vary slightly. With that said, using FICO’s scoring model, your “amounts owed” — which determines your credit utilization, makes up 30% of your credit score rating.
The FICO scoring model looks at your credit utilization in 2 parts. First, it scores the credit utilization for each of your credit cards separately. Then, it calculates your overall credit utilization, that is, the total of all your credit card balances compared to your total credit limits. A high credit utilization in either category can hurt your credit score
If you don’t want your credit utilization to negatively affect your credit score, maintain a credit utilization ratio of 30% or lower.
What is a good credit utilization ratio?
Basic rule of thumb here is to keep your credit utilization ratio below 30% — this is generally considered “good.” A utilization ratio above 30% can do some serious damage to your credit score. Ideally, your ratio should be in the low single digits for the best credit scores.
When is credit utilization reported?
Every month when you pay your credit card bill, you’re affecting your credit utilization rate. The timing of when a credit card company updates your balance information with the credit reporting agencies can affect your credit utilization. Typically, credit card companies update this information every 30 days at the end of your billing cycle.
Does closing a credit card affect credit utilization rate?
When you close a credit card account, you’re reducing your total credit limit. If you owe nothing on your credit cards, your credit utilization rate is zero, and lowering your total available credit won’t change that rate. However, depending on the age of the credit card account that is closed, your length of credit history could be negatively impacted and affect your score.
Use credit the right way
Building credit can feel like a bit of trial and error. Of course your payments are important, but don’t forget about the effect of your credit utilization. Just think of the jar of cookies. Do you want to get sick by eating them all or just enjoy a few? Being responsible and maintaining low balances can be a good step toward improving your credit. You got this!