Credit utilization ratio: What is it and how it affects your credit score

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When it comes to personal finance (including how to get the best credit cards), your credit score plays a large role. Creditors use it as a barometer for how trustworthy you are as a borrower.

One of the main factors used in determining your score is credit utilization, which is a term not everyone is super familiar with. Today, we’re taking a deeper look at what your credit utilization ratio is and how you can maintain a low ratio to improve your credit score.

What is credit utilization?

The term “credit utilization ratio” describes the relationship between your balances and your total available credit across revolving accounts (such as credit cards). It’s the percentage of your credit limits that you are using, as reported by the three credit bureaus. Credit utilization is sometimes also known as your “balance-to-limit ratio.”

You can calculate credit utilization with this simple formula:

  • Credit Card Balance ÷ Credit Limit = Credit Utilization Ratio

Remember, though, that should include all of your revolving credit accounts. So, if you have four credit cards, you’ll want to add up your balance across all cards and the total credit limit across all cards. For example, you have a combined credit limit of $12,000 across two different cards and your credit report shows an account balance of $6,000 spread across those two cards, your credit utilization ratio is 50% ($6,000 ÷ $12,000 = 0.5 X 100 = 50%). In other words, you’re using 50% of the credit limit on your account.

You can also calculate your per-card ratio using the same exact formula, but with that particular card’s balance and credit limit. While your individual cards’ credit ratios are important, the most crucial ratio is your overall average of total credit used to total credit available.

How important is credit utilization?

Credit utilization is one of the more important factors that determine your credit score — depending on which scoring model used, it could make up as much as 30% of your score (such as your FICO score). The only other factor with that much weight is your payment history.

Why does it matter so much? Well, from a creditor’s perspective, it can show whether or not you are doing a good job of managing your credit cards and whether or not you are an over-spender. If you are consistently paying off your balances and not using your full credit limit, that tells creditors like card issuers that you are a low-risk customer. The lower risk you are, the more likely you’ll be approved for a card — as well as any additional credit needs, such as a mortgage and auto loans (with more favorable terms).

What is a good credit utilization ratio?

Credit scoring models reward you when you keep your credit card utilization rate low. If you’re looking for a way to boost your credit scores, paying down your credit card balances (and therefore lowering your utilization ratio) is often one of the most effective ways to accomplish that goal.

Generally speaking, you should aim to keep your total credit utilization ratio below 30%. This is another reason why we recommend paying off your balances in full each month. It’s the best way to avoid interest payments, and it helps keep your credit utilization ratio as low as possible.

If your credit card balance is higher than usual following the holidays, the sooner you pay down those balances — even if it is before your monthly statement closes — the better off you’ll be in regards to your credit utilization ratio.

Why canceling a card could hurt your utilization ratio

When you cancel a credit card, you’re potentially hurting your score in two ways. First, you are taking away from your average length of accounts, especially if you’ve had the card for a long time. Second, you’re potentially increasing your credit utilization ratio.

Let’s say you close a credit card with a $0 balance and a $10,000 credit limit, but still have two other credit cards. One card has a $3,000 balance and a $10,000 credit limit. The other has a $2,500 balance and an $8,000 credit limit. If you cancel that card, your aggregate utilization ratio increases from 19.6% to 30.1%. Because of that, your credit scores may drop, even though your credit card debt is the same amount it was before.

Canceling a card reduces your total credit limit (the denominator in the utilization ratio). For many people, that can result in higher utilization and lower credit scores. Ultimately, whether a credit card closure hurts your credit score largely depends on how many other accounts you have open and how much you use them.

To avoid decreasing your overall credit limit — and thus increasing your credit utilization ratio — you have a few options when you are looking to cancel a card.

First off, you can shift credit from one credit card to another. This only works if you have multiple credit cards within the same bank. Let’s say you have a $10,000 credit limit with a Chase personal card, but you also have a few other Chase personal credit cards in your wallet. Before canceling the card, you can call Chase to transfer your credit limit from the card you are looking to cancel to another card — or cards — in your account. This will keep your credit tied to your account and thus not affect your credit utilization score. Once the credit is relocated from one account to another — which can sometimes take up to 24 hours — you can then cancel the card.

Keep in mind though that each bank has a different set of rules. Typically, there is a minimum amount of credit that you’ll need to keep tied to the card — typically between $1,000 to $5,000 depending on the bank — so you are still losing some credit, but not a significant amount. Additionally, shifting credit doesn’t require a hard credit pull, unless the new card’s limit is to exceed a set number — with Chase your credit limit can’t exceed more than $35,000.

Another way to not lose your card’s credit is to request a downgrade from your issuer to a different product that doesn’t charge an annual fee. This will keep your credit with the new card and have zero impact on your credit utilization score. However, downgrading a card could exclude you from applying for the new card in the future and getting a welcome offer on that particular card.

And if the particular card you are looking to close is a no-annual-fee credit card, you can also keep it open and tucked away in your sock draw. It doesn’t hurt to keep it open, but it does require you to keep an eye on the account just to ensure there’s no fraudulent activity.

Applying for a new credit card

If you are looking to cancel a card at the same time as applying for a new card, best practice is to apply for the new card before canceling the old one. Your existing credit line will still be factored into your score and your utilization ratio will remain low while your application is being considered.

Of course, new applications also have an impact on your credit score. Be sure to consider the situation from multiple angles before you make a decision.

Bottom line

Although it is easy to forget about your credit score when making credit card decisions, it is something that is incredibly important to keep in mind — especially your credit utilization ratio. Since your amount of debt makes up the bulk of your score, keeping your credit utilization in mind is something that should always be considered when canceling and applying for new credit cards.

Having a low credit utilization ratio will only help your credit score, which can lead to a pathway of more favorable credit card, loan and mortgage applications in the future.

The post Credit utilization ratio: What is it and how it affects your credit score appeared first on The Points Guy

Original source: The Points Guy

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