Credit Utilization: Understand How it Impacts Your Credit Score
Though paying your bills on time is one of the best ways to build a good credit score, it's not the only important factor. How much you owe compared with your credit limits -- your credit utilization ratio -- accounts for 30% of your FICO score. That means if you rack up a big balance or max out your cards, you could hurt your score.
Here's what you should know about credit utilization and how it impacts your credit score.
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What Is Credit Utilization?
"Credit utilization is the amount of credit you're using relative to the total credit line you have available," says Howard Dvorkin, a CPA, author, columnist and chairman of personal finance site Debt.com. Usually, your credit utilization ratio is expressed as a percentage. For example, if you have a $1,000 credit line and you carry a balance of $500, your credit utilization ratio would be 50%.
"Credit utilization makes up such a significant part of your score because if you're maxing out credit cards, lenders may assume that you are living beyond your means, ultimately deeming you as a credit risk," says Dvorkin. On the flip side, he says, keeping your credit utilization low shows that you're in control of your spending habits.
When it comes to credit utilization, the closer you are to zero, the better it is for your credit score. "It is universally recommended to keep your credit utilization ratio below 30%," Dvorkin says.
But FICO says a 0% credit card utilization ratio isn't ideal. "That would mean you are not using credit on a regular basis, and lenders do look to see that you can manage credit before they agree to extend a loan or better interest rate," says Freddie Huynh, a former data scientist at FICO and current vice president of credit risk with Freedom Financial Asset Management. "Being able to charge small amounts and then paying them off in full and on time every month is the best strategy."
It's also important to know that credit utilization doesn't just refer to the total amount of credit you're using. Your per-card utilization ratio matters, too. So let's say that you have two credit cards: Credit card A has a limit of $1,000 with a balance of $500, and credit card B has a limit of $2,000 with a balance of $200. Even though your overall utilization would be less than 24% ($700/$3,000), you'd still be penalized because of the high utilization ratio on credit card A.
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Why Credit Utilization Matters
Credit card 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.
"Within the indebtedness dimension of credit score calculation, credit card utilization is consistently found to be highly predictive of credit repayment," Huynh says. "Higher balances are more difficult to afford and could indicate that you're overextended, sending a signal to prospective lenders that there's an increased risk of you falling behind on payments." There are two reasons why utilization is such a powerful indicator: Psychology. If a borrower maxes out every credit card in his or her wallet, that person 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 person is more likely to be 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. [Read: Best Credit Cards for Fair Credit.] Lower Your Credit Utilization and Increase Your Score So what can you do to keep your credit utilization low and improve your score? Keep your utilization rate under 10%. Though most experts recommend keeping your credit utilization ratio under 30%, lower is better. In fact, according to FICO, credit card holders with top scores use an average of 7% of their available credit. To ensure you use enough credit but don't go so high that it harms your credit score, shoot for a utilization ratio of around 10% to be safe. 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. Just be sure to make this request with healthy credit. If your score has dropped since you opened the card or you have fallen behind on payments, your issuer might actually reduce your limit instead. Alternatively, you can apply for a new no-fee credit card to create additional available credit. Pay twice per month. "Another great way to keep credit utilization low is to make payments biweekly as opposed to once per month," Dvorkin says. "This way, you can still use the card throughout the month while still maintaining a 30% limit." Find out when your balance is reported. Your payment due date and the day your balance is reported to the credit bureaus often fall on different days. So even if you pay your full balance at the end of the month, it could have been reported midmonth, making it appear as though you have a high utilization ratio. Ask your issuer when balances are reported so you can pay it off beforehand. Often, it's when your statement closes. Spread purchases across cards. Though you might have one or two cards you prefer to use regularly, it's a good idea to spread out your transactions across multiple cards if you plan to do a lot of spending on credit during a given month. This will prevent your utilization from growing too large on any one card. Keep cards open. If you have a credit card you no longer use, you might be tempted to close the account. However, if you're carrying a balance on other credit cards, this would result in an immediately higher credit utilization ratio since your debt load would remain the same while your available credit decreases. Rather, consider cutting up your card but keeping the account open so you can take advantage of having more available credit. The exception is if the card charges an annual fee, in which case it might not be worth it to keep the account open.
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