Credit utilization

Just imagine—you find your dream home and qualify for the mortgage on your first try. Or you visit a car dealership and snag the amazing offer you saw in a social media ad. Or you decide to consolidate your high-interest credit card debt with a personal loan that charges a fraction of the interest and get approved within minutes of applying.

What these scenarios have in common is healthy credit. And if your credit standing isn’t as excellent as you want it to be, there’s a good chance that utilization is holding you back.

You can be the master of your credit score. Once you understand what factors affect it and how to control those factors, you can do what you need to do to make your credit standing the best it can be. 

Let’s find out what credit utilization is all about.

What is credit utilization?

Here's a simple credit utilization definition: It's how much of your available revolving credit you're using. (Revolving debts are credit cards and personal lines of credit). 

Credit utilization is also called “credit usage” or “balance to limit.” That last one refers to how you calculate credit utilization—by dividing your account balance by your credit limit. 

Here’s how it works. 

If you have a $700 balance on a credit card that has a $1,000 credit limit, your utilization is 70%. Credit utilization describes how much you owe on your credit cards versus how much spending power you have.

There are two ways that credit scores look at utilization:

• By individual card

• For all your credit cards combined

Why does credit utilization matter? 

Credit utilization matters for one reason: it's a big part of your credit score calculations. In fact, the “amounts owed” category (of which credit utilization is one part) makes up 30% of your FICO score. In other words, it’s so influential, even if you do everything else right, a high utilization ratio could hold you back from a higher score.

The total amount of debt you have is part of the equation, but the utilization ratio is what most of us need to focus on. It’s possible to have a great credit standing even if you owe a million dollars on your mortgage, as long as you’re making your payments on time. But if you max out your credit card, your credit profile is likely to suffer. 

A lower credit utilization is a good thing where your credit scores are concerned. 

Using up more of your available revolving credit could work against you. 

For example, if you've got five credit cards and you're maxed out on all five, lenders might raise an eyebrow. It could look like you're desperate for money or careless with spending, which could get you denied new credit cards or loans. 

Higher credit utilization doesn't automatically mean you're bad with money, though. 

Does credit utilization matter if you pay in full?

Credit utilization does matter, even if you’re in the habit of paying off your credit card balance every month. 

Suppose that you charge all your monthly bills to one credit card, then pay it off at the end of each month. Until your credit card issuer reports your payment, your utilization could appear very high. But the fact that you're paying in full (and hopefully, on time) means that you know how to manage your debt responsibly. 

Card issuers often report your data to the credit bureau on the day your statement billing period ends (you can call to find out). To be sure that your utilization is reported accurately, pay off your balance before it’s reported.

How to calculate your credit utilization

Wondering what your credit utilization ratio looks like? It’s not hard to do the math. Here's the formula:

Credit card balance / Credit card limit x 100 = Credit utilization ratio (stated as a %)

Let's look at some examples. 

Say that you have four credit cards:

• Card A has a $2,500 balance and a $5,000 limit

• Card B has a $1,000 and $3,000 limit

• Card C has a $10,000 balance and a $12,000 limit

• Card D has a $500 balance and a $4,000 limit

You can use the formula above to work out your credit utilization for each card separately, then for all your cards together. 

Your utilization calculations for each card look like this:

• Card A: $2,500 / $5,000 x 100 = 50%

• Card B: $1,000 / $3,000 x 100 = 33%

• Card C: $10,000 / $12,000 x 100 = 83%

• Card D: $500 / $4,000 x 100 = 12.5%

To calculate the overall credit utilization for all your cards together:

• Add all the card balances together: $2,500 + $1,000 + $10,000 + $500 = $14,000

• Next, add up all the credit limits: $5,000 + $3,000 + $12,000 + $4,000 = $24,000. 

• Overall credit utilization ratio =  $14,000/$24,000 = 58%

Nothing too tricky about any of the math required. And calculating your credit utilization can give you an idea of whether the way you use credit might be hurting or helping your scores. 

Tips to manage your credit utilization

If you're working on improving your credit scores, then lowering your credit usage is one way to do it. 

There are some different ways of managing credit utilization to help your credit scores:

• Raise your limits. One of the quickest ways to improve your credit usage is to increase your credit limits. Ask each of your credit card issuers for a credit limit increase. Note that if the creditor does a hard credit check, that can have a temporary negative impact on your credit standing. You could also employ this strategy by applying for a new credit card. But the trick is to avoid using it, so the available credit has a chance to help you lower your utilization ratio.

• Pay down balances. Paying down existing balances helps your utilization and your wallet. Consider tackling your debt with the avalanche or snowball method. 

• Consolidate debts. Debt consolidation involves taking out a new loan to pay off credit card balances. Paying off your revolving credit with a personal loan or a home equity loan could drop your utilization to zero. 

• Balance your spending. Even if your credit utilization overall is low, putting too much on any one card could hurt your FICO score or impact your chances with lenders. Try to spread your spending more evenly across your cards.

• Pay your credit card balances more than once a month if you tend to charge a lot. This keeps utilization consistently lower. 

• Create automatic small charges—for instance, a regular bill like Netflix—and then set up an electronic monthly payment to cover it. This is helpful if you don’t use credit very much.

Debt consolidation loans don’t make debt go away. They just change the type of debt you owe. If you move your debt and then run up the balances on the accounts you just paid off, your financial situation could get a lot worse. The same goes if you increase your credit limits and use the extra credit to charge more purchases. 

The myth of the 30% rule

What's a good credit utilization ratio? If you ask some financial experts, they might point you to the 30% rule. 

This "rule" says that an ideal credit utilization ratio is 30% or less. So, if your credit card limits total $10,000, you shouldn't use more than $3,000 of that at any given time. 

But that's just an arbitrary guideline, and it’s not guaranteed to help your score. In fact, FICO suggests shooting for 10% instead and paying bills on time to grow a healthy credit score. 

You might be tempted to go lower than that and reduce your credit usage to 0%. Sounds good, but there's a hitch. If you're not using your credit cards, then there's no activity to report to the credit bureaus. And there might not be any payment history either. Over time, the lack of activity could keep you from earning the highest score possible. Use the automatic bill pay trick mentioned above to use credit, keep utilization low, and build a positive payment history.

How credit utilization affects your financial health

Credit utilization directly affects your credit scores, but there's more to it than that. Maintaining a good utilization ratio is good for your overall financial health. 

Here are a few reasons why:

• Lower credit utilization makes it easier to get approved for new loans or lines of credit. 

• Keeping your balances low means you’ll have emergency credit when you need it.

• Using less credit means less debt to repay. 

• Aiming for a low credit utilization ratio is a good habit that can keep you from overspending and blowing your monthly budget.

• It may be easier to keep up with debt payments (and avoid late payments) if you're not relying heavily on credit cards. 

Now, can high credit utilization hurt? Yes. Increasing balances means you’re spending more than you make. That can’t go on forever because eventually, you’ll run out of credit.

Credit utilization is just one factor that affects your credit

Credit utilization is important, but another factor is even more critical for good credit. That’s your payment history. Other categories like the average age of your accounts and how much new credit you’re applying for also affect your credit score and how lenders view your financial profile. 

Knowing how credit utilization works is just one part of the plan to improve your credit standing. And in the long run, picking up that kind of knowledge can pay off when it's time to borrow.