(Updated 11/28/24)
What is credit utilization, and why do we feel you need to understand this when buying a home or vehicle? Believe it or not, this single factor can make or break your credit score. So grab your compasses and maps as we explore the depths of credit utilization.
What is Credit Utilization?
Credit utilization is the ratio of your outstanding credit card balances to your credit limits. Or – to be more precise and less confusing – how much of your available credit you’re actually using at a given time. Imagine your credit limit as a giant pizza. Credit utilization is the number of slices you’ve eaten. The more slices (credit) you use, the higher your utilization rate, and just like eating too much pizza, it can be bad for your financial health.
Why Does Credit Utilization Matter?
Credit utilization makes up a whopping 30% of your credit score. That’s right, nearly a third of your score depends on how much of your available credit you’re using. Lenders view high credit utilization as a red flag. It suggests you might be over-relying on credit and could struggle to repay your debts. On the flip side, low utilization indicates responsible credit management.
How is Credit Utilization Calculated?
Calculating your credit utilization is pretty simple:
As an example, if you have two credit cards with a total credit limit of $10,000 and your total balance is $2,500, your credit utilization would be 25%.
Ideal Credit Utilization Rate
The golden rule is to keep your credit utilization below 30%. But if you really want to impress the credit score gods, aim for under 10%. Think of it as getting an A+ in Credit Management 101.
How Credit Utilization Affects Your Credit Score
High Utilization: Using more than 30% of your available credit can negatively impact your score. It’s like showing up to a marathon with a donut in each hand – it doesn’t inspire confidence.
Low Utilization: Using less than 30%, and ideally less than 10%, can positively impact your score. It shows lenders you’re a responsible borrower who doesn’t max out their credit cards.
Zero Utilization: Interestingly, using no credit at all can also be a negative. Lenders want to see that you can manage credit responsibly, not that you’re avoiding it altogether.
Tips to Manage and Improve Your Credit Utilization
- Pay Down Balances: The simplest way to lower your utilization is to pay off your credit card balances. Prioritize high-interest debt first to save money in the long run.
- Increase Credit Limits: If you’re a responsible borrower, ask your credit card issuer for a higher credit limit. This can instantly lower your utilization rate, but only if you resist the temptation to spend more.
- Spread Out Charges: Instead of piling all your expenses onto one card, spread them out across multiple cards to keep individual utilization rates low.
- Make Multiple Payments: Consider making multiple payments throughout the month. This keeps your balance low and shows lenders you’re actively managing your debt.
- Keep Old Accounts Open: Don’t close old credit accounts, even if you don’t use them. The available credit from these accounts contributes to a lower utilization rate.
Common Credit Utilization Myths
Myth 1: Carrying a Balance Helps Your Credit Score
- False. Carrying a balance and paying interest does nothing for your score. What matters is the ratio of your balance to your credit limit.
Myth 2: Closing a Credit Card Improves Your Score
- Wrong again. Closing a credit card reduces your total available credit, which can increase your utilization rate and hurt your score.
Myth 3: Using No Credit is Best
- Not quite. Using some credit responsibly is better than using none at all. Lenders want to see a track record of responsible credit management.
Tools to Monitor Your Credit Utilization
- Credit Monitoring Services: These services track your credit utilization and alert you to changes. It’s like having a personal trainer for your credit health.
- Credit Card Apps: Most credit card companies offer apps that show your current balance, credit limit, and utilization rate.
- Budgeting Tools: Apps like Mint or YNAB can help you keep track of your spending and credit usage.
Final Thoughts
Credit utilization is a crucial component of your credit score. By keeping your utilization low, you can demonstrate to lenders that you’re a responsible borrower and improve your chances of securing favorable loan terms. Remember, it’s not just about how much credit you have, but how you use it.
