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Credit Utilization Ratio

Credit Utilization Ratio

Everyone knows that keeping your FICO score (credit rating) as high as possible is very important.  It is equally common knowledge that the most important factor in keeping the score high, or recovering your score, is paying all bills on time.  However, many people may be less clear about the other factors in determining your score.  The rating agencies look at the age of your accounts, the number of times you’ve recently applied for new credit, the types of credit you have, and also your credit utilization ratio.

The credit utilization ratio is becoming more and more important.  The credit utilization ratio is also called the debt-to-credit ratio, and is a number used to quickly measure how much of your available credit is used up.  To explain the term, see the example below:

Mr. Smith has two credit cards.  One card has a $1000 limit and a $200 balance.  The second card has a $1000 limit and a $400 balance.  The scoring agencies will calculate his utilization overall, and per card.

In other words, the overall ratio would be calculated as:

$1000 + $1000 = $2000 total available credit.

$200 + $400 = $600 total balance.

($600 / $2000) x 100 = 30% overall credit utilization ratio on these credit cards.

Independently:

Card 1: ($200 / $1000) x 100 = 20% credit utilization

Card 2: ($400 / $1000) x 100 = 40% credit utilization (this is relatively high – work to keep your ratio below 30% overall and on each credit card).

Why is the credit utilization ratio important?  If you are charging all the way up to the limit on your credit cards, then you are much more likely to default on the debt or to have trouble paying on time.  This means that you are a higher risk borrower, and credit rating agencies will lower your credit score to reflect this.  Alternatively, if you are using your credit cards sparingly and maintaining low balances, you show responsible use of your credit and become a better risk.

Keep in mind that paying off your balance in full every month does NOT guarantee a low credit utilization ratio.  The problem is that your creditors may report the debt-to-credit ratio at any time during the month, and if you have a high balance on the day that they report to the bureaus, then your ratio gets spiked.

One other common misconception on this point is that closing old or inactive credit card accounts can improve your credit score.  Actually, just the opposite is true.  If those inactive accounts are in good status (meaning you have zero balance and a positive payment history), then the credit limit on those credit cards increases your overall available credit limit and helps to keep your credit utilization ratio low.  Closing the account cuts down the available credit and raises the ratio, and that’s what we need to avoid.

How can you correct a high credit utilization ratio?  This is pretty simple to achieve.  You can either pay the balances of your credit cards down as quickly as possible, or apply for an increase in your credit limits.  As soon as either of these is achieved, the ratio will drop and your all-important credit score will go back up, where it belongs!

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