What is the Credit Utilization Ratio
The credit utilization ratio is the percentage of a borrower’s total available credit that is currently being utilized. The credit utilization ratio is a component used by credit reporting agencies in calculating a borrower’s credit score. Lowering the credit utilization ratio can help a borrower to improve their credit score.
BREAKING DOWN Credit Utilization Ratio
The credit utilization ratio is typically focused primarily on a borrower’s revolving credit. It is a calculation that represents the total debt a borrower is utilizing in comparison to the total revolving credit that they have been approved for by credit issuers. When managing credit balances a borrower should also know their current debt to income ratio which takes into consideration both revolving and non-revolving credit and is another factor that is considered when submitting a credit application.
Below is an example of how a credit utilization ratio is calculated. Say a borrower has three credit cards with different revolving credit limits.
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
The total revolving credit across all three cards is $5,000 + $10,000 + $8,000 = $23,000. The total credit used is $1,000 + $2,500 + $4,000 = $7,500. Therefore, the credit utilization ratio is $7,500 divided by $23,000, or 32.6%.
Credit Utilization Ratio Considerations
Shifting credit card 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. Transferring balances to lower interest credit cards however could be beneficial in the long-term since lower interest accumulation can keep balances down.
Closing a credit card account that you no longer use can have a negative impact on your credit score by reducing your total available credit. Thus, if you continue to charge the same amount or carry the same balance on your remaining accounts, your credit utilization ratio would increase and your score may go down.
Inversely, adding a new credit card will help to lower your credit utilization ratio. However, while new cards can be beneficial for credit utilization they may adversely affect your credit score through increased inquiries and lower average account longevity.
A borrower’s credit utilization ratio will vary over time as borrowers make purchases and payments. The total outstanding balance that is due on a revolving credit account is reported to credit agencies at various times throughout the month. Some lenders report to credit reporting agencies at the time a statement is issued to a borrower while others choose to report on a designated day of each month. The timeframe used by lenders for reporting credit balances to an agency can affect a borrower’s credit utilization levels. Therefore, borrowers seeking to decrease their credit utilization must have patience and expect that it may take two to three credit statement cycles for credit utilization levels to decrease when debt is being paid down.