Learn How Credit Utilization Ratio Influences Credit Score
Are you among those individuals who pay off their credit card balances in full every month but still mess-up with the ‘amount-owed’ portion of the credit score? According to FICO, owing money on credit accounts don’t show you as a high risk borrower. The problem arises when you use a high percentage of the available credit, as it reflects that you are more likely to miss payments or make late payments. Credit utilization is an important factor that accounts for 30 percent of an individual’s credit score.
FICO usually differentiates between good and bad debt when calculating your FICO score. While the good debt is the fixed installments that you pay to purchase an asset, your credit card debt falls under the category of bad debt. Your credit score is calculated by looking at the total amount of credit card debt and the credit card utilization rate. Although you can consult a credit specialist to have an in-depth knowledge about the topic, let’s first look into how credit utilization ratio is calculated and the consequences of high utilization ratio to help you monitor your credit report in a better way.
How is the Utilization Calculated?
Overall utilization and individual utilization are the two factors taken into consideration to calculate the utilization percentage for the credit score.
Here’s an example of how this is done:
Credit card 1 – Limit $600, Balance $200
Credit card 2 – Limit $500, Balance $300
Total credit limit – $1100
Total balance – $500
Overall utilization = $500/$1100 = approximately 45 percent
Individual credit utilization is also taken into consideration in addition to the overall utilization ratio. As a result, if an individual has only one credit card account that has a balance of more 25 percent of the credit limit, it will hurt the score, even if the overall utilization is below the mark.
The Negative Impact of High Utilization
Experian Decision Analytics has released a recent data to show the importance of utilization on credit score. The Super-prime customers (consumers who scored more than 900) as categorized on the basis of VantageScore utilize only 5.6 percent of the available credit on an average and the Prime customers (consumers who scored between 700 to 899) use 27.5 percent of the available credit. The subprime customers (consumers who scored between 500 to 639) use 77.2 percent of the available credit. This indicates that high utilization negatively impacts your credit score. The individuals who have high level of utilization are prone to engage in three types of risky behaviors:
Tendency to Borrow More than the Income
A credit card user is usually given a credit limit greater than his monthly gross income. If people max out on the credit limit, they end up spending more than what they earn on a monthly basis. Borrowing money for a planned purchase (good debt) is not a high-risk activity but credit card purchases are not an investment and high utilization demonstrates the inability to spend within limit. If your credit report reflects that you have a high utilization ratio, it indicates a red flag to the lenders and you may find it difficult to get a loan at a lower interest rate.
Payment of Higher Interest Rates for Discretionary Purchase
The interest rates of credit cards are always high and a survey by MagnifyMoney reveals that 76 percent people with credit card debt pay more than 15 percent in interest. It is never a wise idea to borrow money at such a high interest rate to purchase gas or pay restaurant bills. Maxing-out on every credit card owned indicates the incapability to impose self-discipline on spending habits. Statistics prove that people who have a habit of using all the available credit are more prone to borrowing money beyond their capacity and are likely to find it difficult to repay the amount.
What Needs to Be Done?
An individual who has maxed out on all the credit cards is likely to have a low credit score. An individual who has used less than 5 percent of the available credit might have a high credit score – provided the payments are made on time. Individuals need to ensure that they don’t spend more than they can afford to pay off fully by the end of their bill cycle in order to have a great credit score. It is also important to keep the utilization ratio less than 20 percent. Individuals with a lower credit limit need to ask their credit card issuers to increase the limit so that they don’t max out on it or they need to apply for a new credit card. All it takes is careful planning and an understanding of what goes against and in favor of your credit score to fall into Super-prime category.