Thinking of making a big purchase? In most cases, you’re going to require credit.
What is credit utilization?
In simple terms, credit utilization, also known as the debt-to-credit ratio, measures how much of your overall credit limit you use. Typically, credit utilization is calculated for revolving lines of credit, such as credit cards. It does not include installment loans such as student loans or mortgages.
On average, low credit utilization is considered more favorable for building a better credit score. As a rule of thumb, using less than 30% of your total available credit limit is a good credit utilization ratio.
According to an Experian study, the average credit utilization in 2021 was 25.6%. While this may make it seem easy to maintain low credit utilization, remember that 30% is not ideal in all situations.
You may have to maintain a much lower credit utilization ratio to increase your credit score considerably in your credit report. Using less than 10% of your total credit limit is often considered ideal for excellent credit scores.
High credit utilization often correlates with an increased risk of default. It can demonstrate a bad credit handling capability to the lender. This makes sense because individuals maxing out their credit cards might be struggling to manage their finances.
It might also indicate that someone is overspending and relies too much on credit instead of their savings or disposable income. Consequently, they might be unable to make monthly payments or handle a new line of credit.
Why is it important to calculate credit utilization?
Most people purchase their first home through a mortgage. It is implausible to buy your first home upfront unless you are a millionaire. Moreover, myriad other activities require good credit. From buying a car to getting a credit card or taking out a personal loan, credit is essential.
Every time you borrow, the lender verifies your credit score and credit history in detail. Credit scores have a massive impact on your ability to access credit — it is an important factor while determining whether you can qualify for a particular loan and, if you do, the amount that will be sanctioned.
Credit history also determines the terms of borrowing, including the interest rates and the duration of the payback period. Your credit score may impact your ability to rent a home, your insurance rates, cell phone contract, the security deposit you pay on utilities, and more.
Credit scores depend on credit history, and it tracks your credit usage. Its purpose is to inform potential lenders about your ability to handle debt.
Lenders take a risk when they lend to borrowers – this is known as default risk and occurs when the borrower cannot pay back the installment or the loan amount. Hence, it is vital to pay close attention to your credit score, track it, and understand how it’s calculated.
To check all these boxes, you’ll need to be familiar with credit utilization rates, one of the critical components of a good credit score. Credit utilization determines 30% of your FICO score. Your credit utilization can make or break your credit score.
How to calculate credit utilization
To calculate your credit utilization, simply divide your total outstanding balance with your total credit limit.
Example of calculating credit utilization
For example, if your credit card offers a credit limit of $5,000 and your outstanding balance for a particular month is $2,000, your credit utilization will be 2,000 divided by 5,000, which is 0.4. To get this ratio in percentage terms, multiply the decimal with 100; therefore, 0.4 times 100 is 40, or 40%. This number implies you’re using 40% of your total available credit, i.e., your credit utilization is 40%.
It’s generally best to know your credit limit before using your credit card. However, if you do not know your credit card limit, you can find it easily. View the latest copy of your credit card statement, and it should have all the information you need to calculate credit utilization – total outstanding balance and total credit limit. Thanks to digital banking, you can do this in seconds at the tip of your fingers. However, you can reach out to your bank’s customer service or relationship manager if you’re having trouble.
You can also work backward to find how much of your credit limit you can use in each billing cycle to stay under the 30% limit. For example, if the credit limit on your card is $5,000, simply multiply this number by 0.3, and you’ll get $1,500.
If you want to maintain healthy credit utilization, you may want to keep your spending below $1,500 in each billing cycle. As discussed, remember that if you want to be in the highest bracket of credit scores, you may need to use a substantially smaller amount. In this case, to spend less than 10% of your credit limit, multiply 5,000 with 0.1, which is $500.
Lastly, most people have more than one revolving credit source; they have access to multiple credit cards and credit lines. Hence, credit scoring models consider both overall credit utilization as well as per card credit utilization.
To calculate your overall credit utilization, sum your total credit limit and outstanding balance from various cards. Then, divide your aggregate outstanding credit card balance with your aggregate credit limit to get your overall credit utilization.
How to maintain your credit utilization
You can use the following tactics to maintain a low credit utilization ratio:
- Get a higher credit limit on your card
- Use multiple credit cards
- Pay off your debt on the same day
While calculating credit utilization is relatively straightforward, maintaining a low credit utilization rate is challenging. It is easy to lose track of your spending or not budget for unforeseen expenditures.
Get a higher credit limit on your card
Higher credit limits are especially useful to those who constantly tread close to the 30% utilization limit. Getting your credit card issuer company to offer a higher credit limit while keeping your spending the same or increasing it at a lower rate than the increase in your limit automatically reduces your total credit utilization.
Use multiple credit cards
This can also increase your total credit limit. Staying under the 30% ratio may be difficult if you rely on a single card, especially in the case of unforeseen expenditures. We recommend having a few credit cards at your disposal to protect yourself from such risk.
So, if you currently own a single credit card, getting new credit cards from major credit card companies can help you diversify your spending. Now, even if you need to spend the same amount, you can divide that amount across different cards.
Pay off your debt on the same day
This implies using your credit card as a debit card. You do not wait till the end of the billing cycle to clear your credit card debt; you do not let your debt accumulate by paying it off each time you use your credit card. This offers additional benefits — you considerably lower your credit utilization ratio and avoid paying interest on your expenditure.
If you’re wondering why you should consider using a credit card, remember that they offer various rewards ranging from cash back to travel miles along with convenience. Most importantly, credit cards can help you demonstrate your ability to handle credit.
The bottom line
There are several online calculators you can use to calculate credit utilization. Online credit utilization calculators offered by Myfin.us or Bankrate are quick, accessible, and convenient. You simply have to input your outstanding balance and credit limit for each card you own, and the calculator will generate your overall credit utilization ratio. These calculators are ideal for those with multiple cards or who find math tedious.
If you are considering getting another credit card to reduce your overall credit utilization rate, consider Vital Card. We are the credit card that pays you to share and spend responsibly.
Sources
Experian 2021 consumer credit review | Experian
5 ways to keep your credit utilization low | Experian
What is a Credit Utilization Rate? | Experian
Credit utilization calculator | Experian
What is a Credit Score – Credit Score Range | Equifax
What Should My Credit Card Utilization Be? | Experian
Why Would You Want a Good Credit Score? | Experian
Vital Card blog posts are intended for informational purposes only and should not be considered financial or any other type of advice.