What is a Credit Utilization Ratio?
When it comes to your credit score, we all know that things like your account and payment history are factored in. However there is one important component that most people aren’t even aware of – your “credit utilization ratio”.
In a nutshell, it is the percentage of available credit which you are using. Here’s an example:
- Your credit card has a limit of $10,000.
- Your current balance is $1,000.
In other words, out of $10,000 in available credit you are using $1,000. That equals 10% which is your credit utilization rate for this account.
How does it affect your score?
On FICO’s website, there is a good breakdown of what’s in your FICO score. You will see the “amounts owed” category makes up 30% of your score. If you scroll down you will see these two things listed under that category:
- Proportion of credit lines used (proportion of balances to total credit limits on certain types of revolving accounts)
- Proportion of installment loan amounts still owing (proportion of balance to original loan amount on certain types of installment loans)
To put that in layman’s terms, revolving accounts are credit cards. Installment accounts are loans where you pay a fixed amount each month (think mortgage, car loan etc.). So as you see, both types are taken into account when determining your score.
However it’s important to point out that it doesn’t necessarily mean these two components make up 30% of your score (as some sources incorrectly claim). Going back to the aforementioned link on FICO’s site, you will see that under the “amounts owed” category, there are a four other factors which are also included.
- Number of accounts with balances
- Amount owing on accounts
- Amount owing on specific types of accounts
- Lack of a specific type of balance, in some cases
Unfortunately, FICO doesn’t give a breakdown as to how each is individually counted. Rather all they publicly disclose is that those 6 factors – combined – make up 30% of your score.
How to maintain a healthy ratio?
If you do a search regarding what is the best ratio, you will see a wide range of different answers. Most sources tend to say anything higher than 20% to 30% is bad. Meanwhile others claim that anything above 9% should be avoided. So who’s right?
Truth be told, no one knows the answer conclusively. Why? Because FICO’s formula is proprietary and therefore the best we can do is make an educated guess. That being said, if you turn to FICO’s websites there are plenty of clues given.
They have a page about so called High Achievers, which they deem as those who have a score of 760 or higher. On there, they say the average credit utilization ratio for this group is 7% for revolving accounts and 35% for installment accounts. That certainly supports the advice to stay at 9% and under. On the MyFICO forum, this conversation also discusses why staying under 9% is probably best.
But whether you are aiming for 9% or 25% utilization, staying under the level isn’t always straight forward. For starters, it doesn’t matter if you carry a balance or not. Once per month, credit card companies report the amount owed on your account to the credit bureaus. Usually it’s the amount owed which is reflected on your closing statement, but not always. This is why you should stay below your target utilization rate at all times, since you never know what time of month your account will be reported.
To further complicate matters, no preset limits cards can hurt your score. Why? Because without a definitive limit, how can your credit utilization be calculated? Well allegedly your highest monthly balance is used as your credit limit for the calculation. This obviously could pose a problem, unless you have had at least one month where you had an extremely high balance.
Because of this predicament, it’s generally best to avoid having all of your cards be Visa Signature or World MasterCard Elites (which are no preset limit credit cards). Having a couple of them is fine, but just make sure you have others with definitive limits. Examples of good cards that also have set limits include Discover (if you have great credit) and Orchard Bank (if you have fair or bad credit).