Understanding your credit score is like peeling an onion. Under the first layer is another layer and under that is another, and so on. In addition, by the time you’re done peeling it, you sometimes want to cry like a baby.
Joking aside, credit scores are complex and confusing. You can pay all your bills on time every month but continue to have a mediocre credit score. Besides looking at your payment history and the types of credit you carry, the credit-scoring model looks closely at your credit utilization rate.
Don’t start crying yet; it’s actually very simple to understand. Your credit utilization rate is the ratio of your credit card balances and their limits. Essentially, it measures how much credit you have available to you at any given time and how much of it you’re actually using. For example, if you have a card with a limit of $5,000 and you have a balance on that card of $2,500, that card has a credit utilization rate of 50%. Because balances aren’t that conveniently simple, calculate it this way: divide your balance by your limit and then multiply that by 100.
The lower the percentage, the better off you’ll be. It’s regarded by credit card companies as an indication that you use credit responsibly. Looking at how much you’re using vs. how much you have available tells them how much of a lending risk you are, to some extent. They may be cautious about lending you money if you have very high utilization rates because it means you’re nearly maxing out your cards. If you have high balances, potential lenders think it’s likely you can pay them down, making them think twice about lending to you.
Your credit utilization is factored into your credit score; for FICO, it accounts for 30% of your score. Credit utilization is considered in two parts: utilization for each card and utilization as a whole. The lower these numbers in each category, the higher your credit score will be. It’s best for your overall credit score if you can keep your utilization below 30%. However, 30% is not a magic number, meaning that your credit score won’t be much higher if you’re at 29% rather than 30%. Your credit score will get increasingly better the lower your utilization rate.
All of this should mean that a 0% utilization rate is the number to shoot for, right? Think again. As crazy as it sounds, a 0% utilization rate can count against you as far as your credit score is concerned. Scores are based on financial behaviors, and if you have cards but you’re not using them, lenders see you as a greater future risk. They want to see that you have credit and know how to use it responsibly.
How to change your utilization rate
The good news is that your credit utilization rate is one of the fastest things you can change to improve your credit score. Late payments or other derogatory items can take years to come off your credit report, but your utilization rate improves once your balance comes down or your limit goes up.
What can you do?
Make more than the minimum payment
The lower your balance, the lower your usage rate will be. Try to send more than the minimum payment if you can. Use every bonus, raise, rebate, or other monetary windfall to bring that balance down.
If you have more than one credit card, track how much you’re charging on each. If you begin to approach that dreaded 30% mark, use a different one. Spread out your charges among your cards, as having three cards with low utilization rates is better than having one card with a high one.
If you’re not good at tracking your charges yourself, your credit card company may allow you to set up text alerts so you receive a text when your balance is nearing the 30% mark or a specified dollar figure.
Request an increase
You can request a credit limit increase to help improve your credit utilization rate, but be sure not to use that extra credit or you haven’t really accomplished anything. Note before agreeing to the increase that your creditor might peek at your credit report, which would result in a hard inquiry. Hard inquiries remain on your report for two years and too many in that span can affect your score.
Make payments before the end of the billing cycle
Credit card companies report to the credit bureaus at the end of your billing cycle, not on your due date. Therefore, paying down your balance as much as you can before that date will help your utilization rate the most.
Remember, if your creditor reduces your limit for any reason, your utilization rate will go up.
By paying on time, not applying for credit you don’t really need, and keeping a close eye on where your utilization rate is, you can retain a good credit score that’ll enable you to get credit when you need it and at attractive rates.
Remember credit utilization is not a hard concept. It’s just one of those things to keep in mind when trying to build credit. Of course it’s only one of the major factors of credit, it’s also important to protect yourself from scams and identity theft.