All that you wanted to know about credit utilization

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Credit utilization is a frequently used term in any conversation related to credit scores and/or credit reports. In fact, if you’re someone who keenly follows the concept of credit, you must have definitely heard about credit utilization before and would at least have a vague idea about it.

credit utilization

What’s meant by credit utilization?

Technically speaking, credit utilization is the ratio of your credit card balance to your credit limit, taking one or all your credit cards into account. Put another way, it refers to the percentage or extent of open credit you’re presently using.

To give you an example, if the present balance on your credit card is $ 400 and the credit limit available on it is $ 4000, then your card utilization ratio works out to 10%. All you need to do is divide the card balance by the available credit limit, and then multiply the resultant figure by 100.

From the FICO or credit score perspective, the lower the credit utilization, the better it is. Having a low credit utilization implies that you’re using only a small percentage of the credit available to you, suggesting a financially responsible behavior.

Both your credit utilization ratio and the credit score are calculated from the information obtained from your credit report. As all credit card-related information on the credit report gets updated on a monthly basis, any major changes made to your credit limit or card balance recently may not get reflected in your credit or FICO score. Instead, your FICO score is calculated based on the limits and balances existing on your last credit card statement/s.

Furthermore, when it comes to the credit score calculation, the credit utilization is factored in on both per card basis as well as collectively. When done on per card basis, it is referred to as ‘per card utilization’ and when done collectively, it’s called ‘aggregate utilization.’

Aggregate utilization takes into account all the debt owed on various credit lines, and then dividing the total by the overall open credit available on all those lines. Let’s understand it better with an example. So, if you have 4 credit cards with the following balances and credit limits:

Credit card A      –              Balance: $ 4000                 –              Credit Limit: $ 10,000

Credit card B      –              Balance: $ 2000                 –              Credit Limit: $ 6000

Credit Card C     –              Balance: $ 1000                 –              Credit Limit: $ 6000

Credit Card D     –              Balance: $ 2000                 –              Credit Limit: $ 5000

Your aggregate credit utilization would be:

Total credit owed = $ 4000 + $ 2000 + $ 1000 + $ 2000 = $ 9000

Total credit limits = $ 10,000 + $ 6000 + $ 6000 + $ 5000 = $ 27,000

Aggregate credit utilization = (Total credit owed / total credit limits) x 100

Aggregate credit utilization = ($ 9000 / $ 27,000) x 100 = 33.33%

How credit utilization impacts your FICO score?

FICO credit scoring model that’s actively used by Equifax, Experian and TransUnion, the three major credit reporting agencies, employs 5 different category factors in calculation of your credit score. These factors are:

Types of credit or the credit mix – 10%

New credit – 10%

Age of credit – 15%

Total amounts owed – 30%

Overall payment history – 35%

When you see your FICO score, the credit utilization gets featured under the ‘total amount owed,’ and hence is of great importance. Therefore, even if the other factors constituting your FICO score may seem like perfect in every sense, having a high credit utilization can significantly pull down your credit score, owing to the simple fact that ‘total amount owed’ carries 30% weightage in FICO score calculation.

Talking a little more about the ‘total amounts owed’ in the FICO scoring model, it takes into account the following three things:

  • Total amount owed on various instalment loans: Factoring in the amount owed and the original loan balances.
  • Credit utilization on different revolving accounts: A higher credit utilization on different credit lines shows a higher risk of maxing out credit, resulting in inability to make timely payments.
  • Total number of accounts with existing balances: The more the number of such accounts, the higher would be the risk for the lender.

A large majority of people think that the 30% constituting the FICO score is only about ‘credit utilization on different revolving accounts.’ However, as indicated above, there are two more factors at play. So, even if your credit utilization on your credit cards is alright, owing high amounts on your instalment loans, let’s say $ 18,000 owed on an original loan of $ 20,000, will still cause a negative impact on the FICO/credit score.

So, how much credit should you ideally use?

It’s best to keep your credit utilization ratio below 30%. Even though you’d still be carrying some debt with such percentage level, it’d at least be manageable. The lending establishments and credit reporting agencies treat you as maxed out the moment your credit utilization ratio goes over 80% – 85%.

So, it would be fair to say that in theory your credit/FICO score is inversely proportional to your credit utilization ratio. The prospect of maxing out your credit cards is where the per card utilization ratio comes into the picture. While just one maxed out credit card may not cause a lot of damage to your credit score, maxing out multiple credit cards can deal a deathblow to your overall FICO score.

Furthermore, how credit utilization ratio exactly impacts your credit score depends on several different factors, which are often too many to arrive at a concrete formula. So, on the whole try keeping your utilization to the minimum possible.

Final thoughts

Rather than getting over-stressed about the exact percentages impacting your credit score, it would be better that you use your credit responsibly overall. In addition, please also keep in mind that credit utilization is only one factor that determines your credit score, you must give ample importance and attention to other factors too. So, keep your card balances low, limit the number of cards with balances and think twice before opening any new credit.

 

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