Credit Utilization: Understand How it Impacts Your Credit Score

An excellent credit score can make life easier and cheaper. If your score is above 750, you will find it easy to get the lowest interest rates on mortgages, auto loans and credit cards. That score would even get you, in most states, much lower auto insurance premiums. But how do you get a score above 750?

To get an excellent credit score, you need a history of making payments on time. Even a single missed payment can have a devastating consequence. That should not be surprising: Scores predict the likelihood of making future payments on time. If you missed payments in the past, lenders will likely think that you will miss payments in the future.

But to get an excellent score, you need to do more than just make payments on time. One measure -- utilization -- has a disproportionate impact on credit scores.

A recent study completed by MagnifyMoney and VantageScore shows the importance of utilization -- that is, how much credit people are using versus how much credit people have access to. People with scores between 751 and 800 had an average utilization of 12 percent. That means, on average, they are using only 12 percent of their total available credit limits. People with scores above 800 had average utilization of only 5 percent. The higher the utilization, the lower the credit score.

Another trend emerged in the study -- people with bad credit scores tended to have much higher utilization rates. People with scores below 650 had utilization rates at 63 percent or higher.

The importance of utilization only gets clearer when looking at the average balance people carry versus their credit score. People with good and bad credit carry about the same amount of credit debt on average. The key difference is that people with great credit also have much higher available credit limits, meaning that their utilization rates are much lower.

People with the best scores (above 800) have available credit of $46,735 -- 16 times more than the $2,816 of those with the worst scores (below 450). But their outstanding balances are about the same at $2,231 (above 800) versus $2,653 (below 450).

So what is utilization? And why does it matter so much?

[See: 10 Easy Ways to Pay Off Debt.]

Utilization defined. Utilization simply measures how much available credit someone is using. To calculate utilization, divide the statement balance by the credit limit. This measurement is calculated for each credit card and, more importantly, across all credit cards. For example, if an individual has a credit limit of $10,000 and a statement balance of $2,000, then the utilization is 20 percent.

If a borrower has maxed out all of his or her credit cards, the utilization would be 100 percent (or higher).

[See: 12 Simple Ways to Raise Your Credit Score.]

Why does utilization matter? Utilization matters to lenders because the measurement works. Data have consistently shown that people with higher levels of utilization have a higher probability of defaulting. Credit scores are empirically built, and variables are only included in models if their predictive value has been validated. Utilization has been a powerful measurement for decades.

There are two reasons why utilization is such a powerful indicator: psychology and debt-to-income.

Psychology. If a borrower maxes out every credit card in his wallet, he or she is demonstrating a lack of restraint and self-discipline. Credit is readily available in America, and it is very easy for someone to get buried deep in debt. Utilization is simply a measurement of self-restraint. People with the best credit scores have access to a lot of credit, but have the self-discipline to use very little of it. Lenders want to avoid people who are at risk of borrowing too much money because they have a high risk of future bankruptcy.

Debt-to-income. Credit bureaus do not capture income data. However, credit card limits are based on the income declared by borrowers. In most cases, the credit limit is a multiple of the monthly income. A borrower with a $5,000 income would likely get a credit limit of $7,000 or higher. And most people have more than one credit card.

Although credit scores do not use an individual's income, credit scorers can assume that the total credit limits on credit cards are higher than the gross monthly income of that borrower. If someone has a high utilization, that means that they are likely in credit card debt. The higher the utilization, the deeper the borrower's debt, relative to their income. Utilization becomes a proxy for debt-to-income.

Here's how to utilize credit utilization to earn a high credit score.

[See: What to Do If You've Fallen (Way) Behind on Your Credit Card Payments.]

Keep your utilization rate under 12 percent. Once your credit score is above 750, you tend to get the best deals and the lowest rates. People with scores of 750 or higher have an average utilization of 12 percent, according to the MagnifyMoney and VantageScore study. If you make all of your payments on time and keep your utilization around 12 percent (or lower), you can expect to have an excellent credit score.

Give yourself more room to breathe. If your credit limit is just too low, you can always call your credit card issuer to update your income information and ask for a higher limit. Alternatively, you can apply for a new no-fee credit card to create additional available credit.

In general, it is a bad idea to use a credit card to borrow money. If you only use your credit card to make purchases that you can afford to pay off in full every month, utilization should not be a worry.

Nick Clements is the co-founder of MagnifyMoney.com, a price comparison and financial education website. Prior to MagnifyMoney, Nick spent nearly 15 years in consumer banking. Most recently, he ran Barclaycard's UK consumer credit card business. A graduate of Stanford University, Nick uses his knowledge of how the financial system works to help people save money and live financially healthier lives.