WTFinance is a credit utilization ratio and how does it work?

After checking my credit score—and wondering why it wasn’t as high as I thought it should be—I began learning about what’s known as the “credit utilization ratio” and how it affects your score. Utilization is a word you’ll come across a lot when you’re trying to level up your credit score. It sounds more complicated than it is. 

What is a credit utilization ratio?

Utilization is a fancy way of referring to how much of your credit card limit you’re using. It’s a percentage. For example, say you have a credit card:

Card 1: $5,000 limit with a balance of $2,500

In this example, your credit utilization ratio is 50%. You’re using 50% of your available credit limit.

Utilization only applies to credit cards, not personal loans or HELOCs. It’s calculated for each credit card, and overall. 

Let’s say in addition to that first card, you also have two others:

Card 2: $3,000 limit with a balance of $1,000 (33% utilization)

Card 3: $6,500 limit with a balance of $2,000 (31% utilization)

Your total credit utilization ratio is the sum of your balances ($5,500) divided by your total credit limit across your cards ($14,500), or 38%.

How credit utilization affects your credit score

It’s true that your payment history (how consistently you keep up with your payments and make them on time) is the biggest factor impacting your credit score. But credit utilization is the second biggest factor. If you have a high utilization ratio, it might look like you’re headed for a debt trap that you’ll have a hard time getting out of.

That’s why when I had a lot of credit card debt, my score wasn’t as high as I thought, even though I never missed a payment. I was using too much of my available credit.

What’s a good credit utilization ratio?

The best utilization is zero. However, it’s not always possible to pay off your cards every month. According to the credit reporting agency Experian, a good rule of thumb is to try to keep your credit utilization below 30%. In our example, utilization is too high (38%), and there’s a good chance it’s starting to negatively affect our hypothetical person’s credit score. To bring it in line, the total balances across credit cards would need to be $4,350.

Utilization tips and tricks

There are different things you can do with your credit cards that can impact your credit utilization ratio—and influence your credit score.

Don’t max out your cards

If any one card is maxed out or close to being maxed out, your score can suffer. It’s better (for your score) to have two cards, each at 50% utilization, than one maxed-out card.

Open a new credit card to improve your ratio

A new credit card with a new limit increases your total available limit. If you don’t make purchases with that card, your credit utilization ratio automatically drops. Let’s use our example above, and add a card:

Card 4: $5,000 limit with a balance of zero.

Now, the total credit limit is $19,500. If your balance is still $5,500, utilization drops to 28%. That’s how opening a new card can help improve your score, as long as you don’t increase the balance you owe.

There’s a big potential gotcha with this one. Make sure you don’t run up new debt after you open that new card. If the point was to improve your credit utilization ratio, adding more debt works against you. And it’s just more debt you’ll have to pay off. Use the new card with care. Just because you have it doesn’t mean you have to use it. 

Close a card and damage your ratio

Let’s say you’re laser-focused on getting rid of credit card debt. You don’t get that new credit card. 

Instead, you pay off a credit card and you shut down the account to make sure it doesn’t get charged back up:

Card 3: Pay off the $2,000 balance and close the account

Your overall credit limit is now $8,000. You have less debt because you paid off some of it, so your total balance is $3,500.

However, because you closed an account with a higher credit limit, that’s no longer available to you. The new credit utilization ratio is 44%. That could have a negative impact on your score in the short term. 

Paying off cards and avoiding new debt are good things, and for most people, bigger priorities than preserving a few points on your credit score. And in this case, your credit score is likely to go up a little bit every month as you keep chipping away at the remaining debt.

Changing your utilization ratio is one of the fastest ways to change your credit score, but it works in both directions. If you’re learning how to build and maintain great credit, pay your bills on time and focus on lowering your utilization.