What is credit utilization?
Credit utilization is also called debt to credit ratio. In order to calculate this amount you have to divide the total amount of credit available by the total debt thus far incurred. When you do this it provides a measure of “purchasing power” that a cardholder still has. The calculation of this division is converted into a percentage which represents the credit utilization.
How to Calculate this Percentage
Terry Cordell, a member of the Florida Bar and Master in Business Administration in Finance, states that this credit utilization amount actually determines a part of your overall credit score. Up to 30%, reminds Cordell, and yet the majority of Americans do not even grasp what credit utilization means. When new creditors analyze your credit report, they look for the credit utilization and take note of higher numbers, which raises the percentage and thus lowers your score at least by 30% overall.
Therefore it’s important to pay attention to credit utilization when attempting to repair a bad credit score. You’re not simply looking to pay off delinquent debt, but want to stop delinquent debt from ever happening. If you’re carrying an account with a huge debt behind it (like a credit card or loan) then you are closer to a delinquent score than the average credit holder with good credit. The credit report will reflect this potential for high debt.
Start the process by analyzing your credit report. You will notice a figure assigned right after the name of the creditor company, which represents what credit is available to you. This may be referred to as the loan balance, loan amount or credit limit on some credit reports.
For example, let’s say you have a credit card account with a limit of $7,500. Your available credit at one point was $7,500. However, if you made purchases for a total of $5,000 then you only owe $2,500. This will be considered your credit debt. Therefore the formula is as follows: $7,500 available credit, $2,500 credit debt (7500/2500=3) and thus a 30% credit utilization.
In general, you want to keep your credit score high so you must strive for 30% credit utilization (or a third of your total credit limit) on a month-to-month basis. Ideally, a 0 balance is the best. However, owing debt (as long as you meet all minimum payments) isn’t necessarily a negative thing unless you exceed the 30% standard.
What this Credit Percentage Means
Mortgage lenders and other creditors are more likely work with you if you keep the credit utilization percentage down. This shows that you are carefully and effectively managing your
credit properly. On the other hand, having a high credit utilization shows creditors that you may have a problem managing your money.
Some financial experts will tell you that you should avoid canceling your cards because it will hurt your credit score. Is this true? First consider some basics about FICO credit scores. While the credit utilization does account for 30%, this is still relative to payment history (35%), the length of credit history (15%), new credit (10%) and types of credit (10%) that have been used.
It’s important to understand that carrying a balance doesn’t matter. It’s not the fact that you have paid off your debt that matters. What matters is the ratio of credit used to credit available. Even the balances and limits of your account are secondary compared to the credit utilization percentage itself. Therefore, when somebody tells you that canceling your account hurts your score, this is only true if the credit utilization goes up.
For example, you could have two different credit cards with a $500 limit. If you charge 50% of your credit for one, but refrain from charging on the other one, then your total credit utilization percentage is 25% (your combined sum from all accounts). However, if you cancel the second unused card while still keeping the balance on the first, your combined credit utilization now goes to 50% instead of 25%. This is because you have cut off your extra resources. Therefore, you are now a 50% risk because you have less available credit each month. So you would benefit from keeping that second account open.
The Lower the Percentage the Better the Score
In short, remember that the lower the credit utilization percentage, the better your credit score will be. You want to aim for 0% but if you must carry a balance over, aim between 10% (great) to 30% (acceptable) and try not to spend anymore beyond the 30% standard. At the same time, don’t conclude that simply applying for new credit cards will have a positive effect on your credit. Opening a variety of new accounts will hurt you in the “new credit” category. In fact, your credit score lowers slightly every time a new creditor runs your report.
You can compare credit cards using our free credit card chaser web tool. This tool can help you make an informed selection that offers favorable terms. Make your choice carefully and base your selection on which card provides the best terms for a current and debt free account, not an account with a large credit utilization percentage. Use the Credit Card Chaser tool right now and find the right credit card for your budget!