Sometimes overlooked, your credit utilization ratio is an important factor for borrowing, your overall credit score, and can affect your ability to get approved for a loan.
Monitoring your credit utilization ratio isn’t difficult and always advised. It can be an important factor when applying for a loan, and staying aware of where yours is can help with managing your personal finances.
What is a Credit Utilization Ratio?
Your credit utilization ratio is the amount of revolving credit you use, divided by the available to you. A good credit utilization ratio is under 30%.
When lenders look at your credit utilization ratio, it helps them to see how well you manage debt overall. Many consider this the second most important factor, after your credit history, depending on the scoring model.
Some might believe and a great ratio is zero, but it’s best to have low single digits so that your credit profile also sees some credit mix usage on your report. Maintaining a low utilization rate will have a positive effect on your credit score overall.
How to Determine Your Credit Utilization Ratio
Since you determine this ratio based on the amount of credit used divided by what’s available, you would start by identifying your outstanding debt based on revolving credit.
Formula: (Credit Card Balance) ÷ (Card’s Credit Limit)
Let’s suppose you had 2 credit cards. Card number 1 has a limit of $6,000 and you owe $3,000 on this card. That’s a 50% credit utilization ratio on card number 1.
On the second credit card let’s suppose you had a limit of $4,000 and you owe $1,000. That would be a 25% credit utilization ratio on card number 2.
The combined amount of card number 1 and 2 would make your average credit utilization ratio at 40%, which could affect your credit score, and your ability to be approved for a personal loan. Also, even if you were approved for a personal loan, the higher credit utilization ratio might mean that the lender offers a higher interest rate. To maintain a good credit utilization ratio, it should be under 30%, with below 10% is considered very good.
It should be noted that a credit utilization ratio is different from your debt to income (DTI) score and advised you are familiar with the difference and how they can affect your ability to borrow.
How to Improve Your Credit Utilization Rate
When you’re serious about starting to pay down your credit utilization ratio, following some basic steps will help to make progress.
Paying Down Credit Card Debt
To improve your credit utilization ratio the place to start would be paying off your debt. Paying down your debt each month will gradually help, and also have the benefit of lowering the amount of interest that you would need to pay. When trying to pay off credit card debt, it can help if you avoid using your cards altogether. Otherwise, unless you’re really good at managing your debt and finances, you might not make much or any progress to pay down your card debt.
Paying on Time
Ensure that you make payments towards your credit card bill before the end of your billing cycle. If you are unsure when the billing cycle ends, call your credit card company. An alternative is to make multiple payments during the month, but this can be harder to manage.
A billing cycle is the time between the closing date of your last statement and the closing date of your next statement. If your credit card statement is generated each month on the 5th, then the 6th day of the previous month to the 5th day of the current month would be your billing cycle. Any transactions or payments within this date range would appear on this cycle. As you may know, things are often not processed immediately. So plan ahead by making any payments at least 4 to 5 business days before a cut off date.
Note that you should not close your credit card accounts unless it is absolutely necessary, because it might hurt your credit score. The age of your credit history is a factor that takes time and something you can’t improve on easily (like your credit utilization ratio) since it takes time for accounts to mature.
Apply for a Personal Loan
Using a personal loan for debt consolidation will improve your credit utilization ratio. Since these are monthly installment payments where you’re borrowing a fixed amount for a fixed period of time, it is not considered revolving credit and would not directly impact your credit utilization ratio. Not only does this benefit you by reducing the overall interest you might pay without doing this, you could also be offered better rates or APR the next time you choose to borrow.
One of the easiest ways to improve your credit utilization rate/ratio would be to request an increase on the limit of your credit cards. But if you’re not great with managing your balances and have debt, this might create more issues and more debt, so this isn’t advised for everyone. Your best move is to take care of your credit card debt, which will help with improving your credit utilization ratio and score.