Your credit score is made up of five factors. The largest factor is your payment history or how well you pay your bills on time. The second factor is the credit utilization rate or
how much credit you have outstanding compared to your available balance. That makes the way you use your credit a very important factor.
Keep reading as we dive further into credit utilization and how it affects you.
What is the Credit Utilization Rate?
Here’s a simple way to look at your credit utilization rate:
You have a credit card maximum balance. This is the amount of credit the credit card company gives you. Let’s say it’s $2,000. You then have the ability to charge up to $2,000 without going over the limit. How much of that credit you use is your credit utilization. Let’s say you used $500 of it. You would have a credit utilization rate of 25%. You would have used up $500 of your available credit, leaving $1,500 free.
You can figure out your own utilization rate with the following calculation:
Amount of outstanding credit/Total credit limit =utilization rate
How Do Credit Bureaus Look at Your Credit Utilization Rate?
Your utilization rate is looked at twice by
the credit bureaus. They look at your individual credit cards to see how you use them. They also look at your total utilization rate, which combines all of your credit cards and balances together.
It’s in your best interest to keep the rate of both categories as low as possible. Let’s look at an example:
You have 3 credit cards:
- Credit card A has a $200 balance and a $1,000 credit line
- Credit card B has a $500 balance and a $2,000 credit line
- Credit card C has a $600 balance and a $1,000 credit line
Your utilization rate on Credit Card A is the smallest at 20% and Credit Card C has the highest ratio at 60%.
When you combine them together, you have a utilization rate of 32.5%
What is a Good Credit Utilization Rate?
According to most lenders, you should keep your utilization rate below 30%. Ideally, you should keep it at 20% of your available balance, but definitely no higher than 30%. The higher your credit card balances, the higher your risk of default becomes, in the eyes of any new lender. Studies have shown that consumers with
high credit card debt are the first to default on their loans.
Lenders often look at high utilization rates as financial irresponsibility. You overspent or overextended yourself and now you are paying the price. Your credit score will lower as a result of the higher rate and lenders will look at you as a risky borrower.
How Do You Keep Your Rate Low?
The bigger question then, is how do you keep your rate low? The easy answer is to not charge anything. If you do, keep the balances as low as possible. Know your credit limits and keep your balances at 20% or less of the limit.
It doesn’t help to charge a large percentage of your credit limit and then pay it off that month. You won’t know when your credit card company reports the account to the credit bureaus. If they report it before you pay it off, they will see the high utilization rate.
This doesn’t mean that you should not use your credit cards, because regular use and regular payments can help your credit score. What it means is that you should use your credit cards responsibly. Think of your utilization rate before you charge something. Are you already near the limit or have you charged a lot lately? If so, think about the purchase and whether it’s truly necessary. Are you overextending yourself? These are the things the lender is going to think about when deciding if you are a good candidate for a loan, so make your decision wisely.
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