Understanding your credit utilization ratio is easier than you think. Gone are the days when complicated algorithms were kept under lock and key. The good news is that you do not need a degree in rocket science to learn these simple truths. In this short article, we simply explain the definition of credit utilization, how credit utilization affects your credit score, and important considerations you need to know when calculating your own credit utilization ratio.
A simple explanation of credit utilization
A credit utilization ratio is defined by the amount of credit you use compared to your credit limit. In other words, a credit ratio is the amount you owe divided by the amount of money you can spend. To calculate your credit utilization ratio, follow this ridiculously easy formula. First, find the amount you owe and divide it by your credit limit. Next, take that number and convert it to a percentage. Then, you will have your credit utilization ratio. It is as plain and simple as that. To simplify things even further, here is a real world example. If your credit limit is $1,000 and you owe $300, your credit utilization ratio would be 30%. Thankfully, if you need help, there are plenty of online calculators that will help you calculate this score.
How credit utilization affects your credit score
According to the FICO model, your credit utilization determines up to 30% of your score. In short, that means you should avoid maxing out your credit cards altogether. Aim to keep your balances low, ideally under 30% of your credit limit. Lower credit utilization ratios can contribute to higher credit scores. A good credit utilization ratio shows that you have a good history of paying back what you owe. The higher your credit utilization ratio, the more likely it will decrease your credit score. A lender or credit company might identify this as a potential risk and offer you a higher interest amount or worse, deny your application altogether. Seek to keep tabs on your expenses to avoid overusing your credit cards by using online budgeting tools and automating your savings on a monthly basis.
Important considerations for credit utilization
Although some financial gurus prioritize cash as a means of purchasing daily goods and services, the reality is that creditors prefer some use of credit. If you have no credit history, lenders have difficulty analyzing your credit profile due to a lack of information. Of course, if you struggle with overspending, try charging only regular expenses like groceries or gas, expenses you know that you can pay in full every month. Avoid opening too many accounts and periodically ask for a credit limit increase. Lastly, credit utilization is based on revolving accounts like credit cards, so mortgages and automobile loans will not count against your score. By mastering these easy credit utilization tips, you can significantly boost your credit score and save thousands in interest and fees over time.