Credit Utilization Ratio: Definition, Importance, and How does it work

Credit Utilization Ratio: Definition, Importance, and How does it work

Credit Utilization Ratio is a factor Credit Bureaus consider when calculating a borrower’s credit score. It is important to have a low percentage of available credit used to build and maintain a good credit score. New credit card and loan applications are often denied when the credit utilization ratio is excessively high. 

Most credit ratings take current debt and credit limit information into account. The credit usage percentage varies when a person makes payments and purchases. Credit scores are raised by using less of one’s available credit. The credit usage ratio and credit score both benefit from debt reduction.

What is the Credit Utilization Ratio?

The credit Utilization Ratio is the proportion of available credit being used. Utilization rates are calculated exclusively based on revolving credit, which refers to credit cards and other lines of credit. The rates do not cover payments made over time, such as those for a mortgage or a car loan. These things have a varied impact on the calculation of credit scores.

What is the Importance of the Credit Utilization Ratio?

A low credit usage rate is important to establish and maintain a good credit score. New credit card and loan applications are rejected if the credit usage ratio is too high.  A credit report is updated with further information, such as credit score, ratio, and credit limit, every 30 to 45 days (depending on the agency that maintains it). Furthermore, it is often helpful to have some activity on the account; a credit use percentage of 1% looks better in certain instances than 0%.

How does Credit Utilization work?

A strong grasp of how the credit utilization ratio works, how using credit cards affects the credit utilization rate, and how to calculate the credit utilization ratio is necessary for effective credit management. Learn in further detail what credit use is, why it’s important to keep it at a low level, and how a credit utilization calculator helps track the debt-to-credit ratio in a financial situation.

The major focus is often placed on the borrower’s available revolving credit to determine a borrower’s credit usage ratio. The debt utilization ratio compares the total amount of debt a borrower presently utilizes and the total amount of revolving credit providers have allowed. Maintaining a record of the amount paid each month toward debt reduction is an effective strategy for rapidly reducing debt. One aspect that is considered when concluding whether or not to grant a credit request is the ratio that has been sought. 

What is an Example of a Credit Utilization Ratio?

The sample calculation for a credit utilization ratio is below for reference. Consider a borrower with three credit cards, each with a unique maximum permissible revolving balance.

  • Loan Amount: $ 12,000; Current Balance: $2,000
  • Loan Amount: $ 6,000; Current Balance: $1,500
  • Loan Amount: $ 7,000; Current Balance: $5,000.

The combined limit of revolving credit for all three cards is $25,000, equal to the sum of $12,000, $6,000, and $7,000, respectively. The entire amount of credit used is $2,000 plus $1,500 plus $5,000, which is $8,500. Therefore, the portion of available credit utilized is $8,500 divided by $23,000, which is 34%.

What is a Good Credit Utilization Ratio?

A good credit utilization ratio is below thirty percent. Lower usage rates boost and help develop a credit score. It is in the best interest to monitor credit to keep an eye on the percentage of the available credit used and the other elements that influence credit ratings. Paying down credit card bills is the most effective approach to lower the use of the available credit.

What does a High Credit Utilization Ratio mean?

High credit utilization means paying a large amount of the monthly income on debt, which raises the chance of defaulting (at least in the eyes of creditors). Consequently, having a high usage ratio negatively affects credit ratings and makes lenders unwilling to provide extra loans. A low overall usage rate mitigates the negative effects of having a high balance-to-limit ratio on one of the cards, provided that having a low overall utilization rate. Eliminating maximum credit limits that are now accessible is another bad idea.

When is the Credit Utilization Ratio Reported?

Credit card issuers reported credit utilization after the payment cycle once every thirty days. The amount to pay towards the credit card balance each month affects the percentage of the available credit used. It is essential to understand that when a credit card business updates the balance information with credit reporting agencies, it affects the credit use rate and credit scores. The effect of a payment taken on one of the credit cards is shown in the credit scores for a few weeks after the credit card issuer updates the information on the balance with the credit reporting bureaus. There is still a chance that this occurs if choosing to use the card in question for the purchase.

What does a Low Credit Utilization Ratio mean?

A low credit usage rate indicates utilizing a small portion of the available credit and controlling spending. It assists in achieving better credit scores. A higher credit score makes it easier to qualify for larger loans and better interest rates when needed, including car loans, mortgages, and credit cards.

How to Calculate Credit Utilization Ratio?

The calculation of credit utilization is simplified to two digits. One of these factors is the total amount of debt accrued across all the accounts with a revolving credit limit. The other is the maximum amount of credit used.

Follow these four steps to determine how much available credit is used. Determine credit usage using this formula.

Step 1. Bring all the balances for revolving credit accounts.

Step 2. the total of all of the credit limits.

Step 3. Divide the total balance on all the revolving credit cards (from Step 1) by the available credit limit (Step 2).

Step 4. determine what credit usage looks like as a percentage; take the value from Step 3 and double it by 100.

Consider the case when the only source of financing is a credit card with a $2,000 limit. Having a debt of $1,000, the proportion that represents the credit usage ratio when presented as a ratio would be 50%.

How to Improve Credit Utilization Ratio?

One of the simplest and fastest strategies to raise a credit score is to reduce the credit utilization ratio. Here are four strategies that help cut debt, expand credit options, and profit from a reduced credit usage ratio.

  • First, pay off debts. Paying off credit card bills is the greatest way to reduce the credit usage ratio. It’s a win-win situation since every dollar lowers overall debt and credit usage percentage. Paying off bills prevents interest from accruing. 
  • Second, open a credit card for balance transfers. Opening a new line of credit using a balance transfer card increases the available credit. A debt transfer credit card is a good option if having trouble paying down balances because of the interest charged monthly. Moving all the balances to one card simplifies the debt repayment process and saves time in the long run. The best balance transfer credit cards provide introductory interest-free payment plans of 15 to 21 months.
  • Third, ask for a credit limit increase. Asking credit card issuers to raise the credit limit is another effective approach to reducing the credit usage percentage. Available credit increases if raising the credit limit, resulting in less credit being used overall. Just be cautious to avoid incurring further debt with the new credit.
  • Fourth, make a new credit card application. Applying for a new credit card is an effective strategy to reduce the credit usage percentage. Having numerous credit cards connected to the account gives access to additional credit, which reduces the credit utilization ratio assuming the spending remains the same. 

How does Credit Utilization Ratio Impacts Borrower?

The credit utilization ratio impacts borrowers because one factor determining the credit score is the proportion of the available credit being utilized. It is in everyone’s best interest to keep that proportion as high as possible while simultaneously bringing the overall debt burden down to the lowest level that is practically practicable. The credit utilization ratio increases when habitually carrying a load from month to month, negatively influencing credit score.

How Credit Card affects the Credit Utilization Ratio?

The use of credit cards affects the credit utilization ratio by lowering the amount of debt owed. Cardholders with an excellent credit history who cannot pay off balances find that a balance transfer card benefits their financial situation. Credit cards with debt transfer options often provide initial 0% annual percentage rates (APR), allowing one to make payments without worrying about interest costs building up.

Credit usage accounts for 30% of the FICO® Score, making it the second most influential element after payment history. Another common credit scoring methodology uses this factor as 20% of a person’s overall score, called the VantageScore. Though it only contributes 3% of the score, VantageScore considers available credit (the credit limit is less than the current amount).

How much does Credit Utilization Affect Credit Score?

The lower the credit use, the higher the credit score. Dvorkin recommends keeping service below 30% for a good score. However, it’s more of a guideline than a rigid cut-off; decreasing credit usage from 30% to 29% won’t enhance the score.

Does the Credit Utilization Ratio Affect the Credit Score?

Yes, credit utilization affects a credit score since it is a factor that creditors consider when determining creditworthiness. Credit scores drop if too much of a person’s available credit is used. Reducing debt to below 30% of available credit is the first step toward better credit usage. Keeping a card open after the debt has been paid in full is another option, as is applying for a new card or increasing the limit on an existing one. But timely debt repayment is the greatest strategy to increase credit use.

Personal Finance Writer at Payday Champion

Kathy Jane Buchanan has more than 10 years of experience as an editor and writer. She currently worked as a full-time personal finance writer for PaydayChampion and has contributed work to a range of publications expert on loans. Kathy graduated in 2000 from Iowa State University with degree BSc in Finance.

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