What is the 'Credit Utilization Ratio'
The percentage of a consumer’s available credit that he or she has used. The credit utilization ratio is a key component of your credit score. A high credit utilization ratio can lower your score, while a low credit utilization ratio can raise your score. FICO’s credit-scoring formula assumes that consumers who use more of their available credit are riskier borrowers than those who use less of their available credit.
The credit utilization ratio is the amount of outstanding balances on all credit cards divided by the sum of each card's limit, and it's expressed as a percentage. Credit issuers like to see a credit utilization ratio of approximately 35% or less.
BREAKING DOWN 'Credit Utilization Ratio'
Here’s an example of how your credit utilization ratio is calculated. Say you have three credit cards.
Card 1: Credit line $5,000, balance $1,000
Card 2: Credit line $10,000, balance $2,500
Card 3: Credit line $8,000, balance $4,000
Your total credit line across all three cards is $5,000 + $10,000 + $8,000 = $23,000, and your total credit used is $1,000 + $2,500 + $4,000 = $7,500. Your credit utilization ratio is $7,500 divided by $23,000, or 32.6%.
Shifting balances from an existing card to another will not change the credit utilization ratio, as it looks at the total amount of debt outstanding divided by your total credit card limits. In this case, you would be better off paying down debt as opposed to shifting from one of your credit cards to another.
Closing a credit card account that you no longer use can have a negative impact on your credit score. Closing the card reduces your available credit amount, so if you continue to charge the same amount or carry the same balance on your remaining accounts, your credit utilization ratio will increase and your score may go down.
You might think the opposite would be true if you opened a new account — that your credit utilization ratio would go down and improve your score. While getting a new line of credit will increase your available credit, and if you use little of your credit line, your credit utilization ratio may go down, your credit score will not necessarily go up. Applying for a new credit card has a slightly negative effect on your credit score in the short term, and having too many new cards can also negatively affect your score. FICO does not recommend that consumers apply for new credit solely for the purpose of trying to achieve a higher credit score.
For the purposes of calculating your credit utilization ratio, it does not matter whether you carry a balance from month to month or pay off your balance in full each month. The total balance that is due on the date your credit card statement is issued is the balance that gets reported to credit bureaus, and that sum is considered the amount of credit you are using. One way to keep your credit utilization ratio low is to pay your balance before each statement is issued. The positive effect this strategy can have on your credit score can be helpful in getting approved for a loan and getting a good interest rate if you want to borrow money to buy a house, a car or anything else that depends on your credit score.