What You Should Know About Credit Utilization Ratios

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If your credit score is dropping despite a consistent history of on-time bill payments, you might be wondering, "What gives?" Sure, your credit card balances are usually close to the credit limit. And, there were those over-the-limit fees from earlier this year. But is that enough to cause your score to dip?

While payment history takes front and center in determining credit risk, your credit utilization ratio comes in at a close second. Here's what you should know about credit utilization ratios and how they can affect your credit score.

What is a Credit Utilization Ratio?

Credit utilization ratios, sometimes called credit utilization rates, are a calculation used by credit scoring agencies to measure the amount of revolving credit you're currently using compared to your total credit limit. Revolving credit includes credit cards and lines of credit as opposed to mortgages and auto loans.

For example, suppose your total credit limit across all credit card accounts is $5,000, and your total balance is $2,500. In that case, your credit utilization ratio is 50%. Ratios may be calculated using the total amount of available credit associated with your entire credit profile or figured on a per credit account basis.

Scoring agencies, like VantageScore®, recommend consumers keep their ratios below 30% to maintain good credit. Experian®, one of the major credit reporting bureaus, recommends consumers keep their ratios in the low single digits if they hope to achieve and maintain excellent credit.

Credit Utilization Affects Your Finances

While you shouldn't fear using the credit lines you've been given, understanding how they affect your finances could lead you to use them in a way that supports your money goals. Credit utilization ratios influence your credit score and affect your ability to:

  • Secure low-interest rate financing
  • Obtain new credit, including mortgages and auto loans
  • Receive credit line increases since some creditors may be unwilling to grant additional credit to account holders who are at or near their limits

If you have a high credit utilization ratio, the ability to make additional purchases using your current credit lines will be limited. In addition, when you've maxed out your credit lines, funds may be unavailable when you need them most.

Tips to Improve Your Credit Utilization Ratio

While you might be tempted to stop using credit altogether in an attempt to lower your ratio, doing so is ill-advised. Potential lenders prefer that applicants have a recent history of credit usage so they can assess the risk of extending additional credit. Large or multiple credit lines won't harm your ratio as long as you manage them responsibly.

Focus on improving your credit utilization ratio by taking charge of your finances in other ways, such as:

  • Pay down outstanding balances. As long as account balances remain low, your credit utilization ratio should decrease.
  • Set a credit limit for yourself that's 30% of the one granted by the creditor. For example, if the total credit line is $5,000, act as if your credit limit is $1,500. 
  • Keep accounts open after you've paid them off. Even if you haven't used the credit line for months, the account's credit limit may be included in your credit utilization ratio.
  • Be patient. Your credit activity is typically reported at the end of each billing cycle. The creditor may take up to 30 days to update your information with each credit reporting bureau. It will take time for your improved credit utilization ratio to be reflected in your credit score.

It's possible to adjust the dial on your credit profile. Warm up your credit utilization ratio by monitoring credit usage. It could help lay the foundation for a firm financial future.