Credit utilization is a term used to describe the amount of credit a person currently uses for the total amount of credit available. It is represented as a percentage obtained by dividing the outstanding balance into all credit accounts by the total credit limit across all accounts.
The credit Utilization Ratio is found using formula –
Credit Utilization Ration =
For example, if someone has a total credit limit of Rs.10,00,000/- across all their credit accounts and has a balance (amount owned) of Rs.2,00,000/-, then
Credit utilization is an essential factor credit bureaus use to calculate credit scores, providing insight into a person’s ability to manage credit responsibly. When credit utilization is high, a person may rely too heavily on credit, which can be a red flag for lenders. Conversely, when credit utilization is low, it suggests that a person uses credit conservatively and is less of a risk to lenders.
In this article, we’ll explore credit utilization in more detail, including why it matters, how it affects credit scores and strategies for managing credit utilization effectively.
Why Credit Utilization Matters?
Credit utilization matters for several reasons. Firstly, it provides a snapshot of a person’s current debt load and their ability to manage it responsibly. High credit utilization rates suggest that a person may be carrying too much debt, which can make it harder to make payments on time and ultimately lead to default. This can damage a person’s credit score and make it harder for them to obtain credit in the future.
Secondly, credit utilization is an essential factor that credit bureaus use to calculate credit scores. Credit scores are a numerical measure of a person’s creditworthiness and are used by lenders to evaluate credit applications. The higher a person’s credit score, the more likely they are to be approved for credit and at more favorable terms (e.g., lower interest rates, higher credit limits, etc.).
Credit utilization is one of several factors that affect credit scores, but it is a particularly important one. In fact, according to FICO, the company that produces the most widely used credit scoring model in the United States, credit utilization accounts for 30% of a person’s FICO credit score. This means that even small changes in credit utilization can significantly impact a person’s credit score.
How Credit Utilization Affects Credit Scores?
As mentioned, credit utilization is a crucial factor credit bureaus use to calculate credit scores. The relationship between credit utilization and credit scores is sometimes complicated, however.
On the one hand, high credit utilization rates can harm credit scores. This is because high credit utilization suggests that a person may be relying too heavily on credit, making them riskier borrowers in the eyes of lenders. When credit utilization is high, it can indicate financial distress, which can lower a person’s credit score.
On the other hand, low credit utilization rates can positively impact credit scores. This is because low credit utilization suggests that a person uses credit responsibly and is less risky to lenders. When credit utilization is low, it can be an indicator of financial stability, which can raise a person’s credit score.
However, having no credit utilization at all can harm credit scores. This may seem counterintuitive, but having no credit utilization means there is no evidence of a person’s ability to manage credit responsibly. As a result, credit bureaus may view a person with no credit utilization as a higher risk than someone with low credit utilization.
The ideal credit utilization rate varies depending on who you ask, but generally, most experts recommend keeping it below 30%. If someone has a total credit limit of Rs.1,00,000/-, they should save their outstanding balances below Rs.30,000/- (30% of Rs.1,00,000/-). Of course, the lower the credit utilization rate, the better. Some experts suggest aiming for a credit utilization rate of 10% or less, which indicates excellent credit management.
Managing Credit Utilization
Given the importance of credit utilization, it’s essential to manage it effectively. Here are some strategies for doing so:
Monitor your credit utilization regularly:
Knowing your credit utilization rate is essential. You can do this by checking your credit report or using a credit monitoring service. Some credit cards also offer free credit score monitoring, which can help track your credit utilization rate over time.
Pay down outstanding balances:
The easiest way to lower your credit utilization rate is to pay down outstanding balances. If you have high balances on your credit cards or other credit accounts, consider making larger payments or paying more frequently to bring those balances down.
Increase your credit limit:
Another way to lower your credit utilization rate is to increase your credit limit. This can be done by requesting a credit limit increase from your credit card issuer or by applying for a new credit card with a higher credit limit. However, it’s essential to use caution with this strategy, as it can backfire if you take on more debt than you can handle.
Use credit strategically:
To keep your credit utilization rate low, it’s essential to use credit strategically. This means only using credit when necessary and avoiding carrying balances for long periods. If you need to maintain a balance, keep it as small as possible and pay it off quickly.
Don’t close credit accounts:
Closing credit accounts can hurt your credit utilization rate by reducing the amount of credit available. Instead of closing accounts, consider leaving them open but not using them or using them sparingly to keep them active.
Credit utilization is a critical factor that affects credit scores and is an essential indicator of a person’s ability to manage credit responsibly. It’s crucial to keep your credit utilization rate below 30% and manage your credit accounts strategically to avoid carrying high balances for long periods. By monitoring the credit utilization rate regularly and managing it effectively, one can raise credit scores and boost the chances of being approved for credit at favorable terms.