What is a Utilization Ratio and Why Does it Matter?
What is Utilization Ratio and Why Does it Matter?
Most of us have a credit score, and it’s not just about paying your bills on time. Obviously, that helps, but how you use your credit cards – your credit utilization ratio – is also very important. It has a direct impact on your FICO® credit score, 30 percent of it, in fact.
Your utilization ratio is one of the most important factors that influence your overall credit score and a lender’s decision to extend credit to you. Many people don’t know what a utilization ratio is or believe it refers only to how much they owe versus their income.
Understanding a Utilization Ratio
The utilization ratio is calculated based on the amount of outstanding debt you have on all revolving accounts versus your available credit. Revolving accounts include credit cards and other accounts that may have a maximum credit limit, and allow the borrower to pay down the balance owed and re-use that available credit line. While credit cards are a big part of your credit utilization ratio, it is also calculated based on all types of revolving accounts, like signature lines of credit and Home Equity Lines of Credit (HELOC).
Calculate your utilization ratio by dividing the total outstanding debt on a revolving account by the amount of available credit. For instance, suppose you have a credit card with a $1,000 limit. If you have a $400 balance on it, then the credit utilization is 40%. The higher the ratio, the more the negative impact will be on your credit score because lenders equate it with a higher chance of default or bankruptcy.
Ideal Utilization Ratios
Lenders have been using the ratios to calculate credit scores for decades, based on a predictive model that seems to be highly accurate. The ratio is the measure of financial discipline, and people with high credit scores and access to a lot of credit tend to use very little of it.
Your credit score is not calculated using your income data, but your credit utilization ratio can be representative of your income. Lenders know that credit card limits are primarily granted based on the income you declare. Thus, using the calculations, a higher utilization ratio typically reflects a higher debt to income ratio, which is a red flag for lenders indicating the applicant may already be over-extended.
Improving Your Utilization Ratio
Studies show that people with higher credit scores have access to more available credit even though they don’t use much of it. On average, people with low credit scores tend to carry a similar amount of debt as those with higher scores. The difference is that those with higher limits have a lower utilization ratio because they use less of their available credit, overall. That means they enjoy lower interest rates, have more negotiating power, have higher credit scores, and even get better rates on car insurance. And, there are many other benefits, like the likeliness of being considered for a job ahead of others with a lower credit score.
Improving your ratio will have a positive impact on your credit score almost immediately, and reducing your debt is the best way. It takes time to pay down balances, however, and leaves you stuck paying higher rates in the interim. Calling your credit card companies to ask for an increase in your credit line may help, but if you have a history of late payments, they may not oblige you because of the potential risk. The great news is that you have another option.
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