Fact: the two most important factors that go into calculating your credit score are payment history and credit utilization. Payment history makes up 35% of your credit score and is easy enough to understand. Essentially it boils down to two things: making regular, on-time payments every month? Good. Being 30 days or more late on your payments? Bad. It’s all about covering your expenses. But what the heck is this credit utilization thing? That’s a little more complicated.
Understanding credit utilization is crucial for maintaining a healthy credit score. Basically, credit utilization is the percentage of your available credit that you’re actually using. For example, if you have a credit card with a $5,000 limit and you have a balance of $1,000, your credit utilization rate is 20%. It’s important to keep your credit utilization rate low because it makes up a significant portion of your credit score — 30%, in fact. But we’re about to do a deeper dive into all of that.
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What is credit utilization?
To find your credit utilization rate, you’ll need to know how much credit has been extended to you and how much of it you’re actually using. That way potential lenders can be sure that you’re not stretching yourself too thin financially.
Help! Math is hard.
Figuring out your credit utilization ratio is mathematically simple but can be emotionally exhausting depending on how bad your situation. Don’t worry, though. We’re here to hold your hand through each step of the equation.
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Add up the amount of credit that’s been extended to you.
First, you’ll need to add up the amount of credit that’s available to you. Let’s pretend you have credit cards from the following banks with the following line of credit limits, bearing in mind that all these numbers are made up for example’s sake:
- Bank of America: Credit limit of $5,000
- Citi: Credit limit of $3,000
- Capital One: Credit limit of $10,000
- American Express: Credit limit of $2,000
- Home Depot Credit Card: Credit limit of $1,000
Your total credit limit across all five of these cards would be $21,000.
Next, add up the total amount of debt you’re carrying.
This part might be unpleasant, depending on your situation, but you’d need to take a long, hard, honest look at how much you currently owe on each card. For example’s sake, let’s say you owed the following amount:
- Bank of America: $4,000
- Citi: $500
- Capital One: $5,000
- American Express: $300
- Home Depot Credit Card: $0
Your total debt burden across all cards would be $9,800.
Divide your total debt burden by your available credit.
Now that you’ve gathered all your numbers, you get to the easy part of the math. Simply take the total debt you owe across all cards and divide it by your total credit limit.
For the above scenario, the math would look like this:
$9,800 / $21,000 = About 47%
Because the math is cumulative, you generally don’t want to close a credit card unless you absolutely have to. You might not currently use that Home Depot credit card, but the $1,000 credit limit is helping to lower your overall credit utilization. Without it, your rate would jump up from 47% to 49%.
Try to keep that number under 30%.
Generally speaking, you want to keep your credit utilization under 30% if you want to get approved for the best rates on new lines of credit or loans.
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Doing the math on installment loans.
Credit cards are one thing, but how do you measure your credit utilization on something like a car loan or mortgage?
First, you’d take into consideration the total amount you originally borrowed. This is important: for this first part, we’re not looking at how much you currently owe. Instead, we’re looking at how much you originally owed.
As an example, let’s say you initially borrowed $16,000 for your car.
Now you can take a look at the amount you currently owe. Let’s say you’ve got it down to $8,000 if you hypothetically paid off the car today.
You’d then take the amount you owe and divide it by the original loan amount:
$8,000 / $16,000 = 50%
Installment loans are a little more finicky. The idea is that over time they’ll help your credit score as you make on-time payments. You’re not expected to perpetually hold your ratio under 30%. There’s an understanding that early on in the loan it will be higher.
Plus, when you pay your installment loan off early, you may see a slight dip in your credit score. This is because open accounts with a history of on-time payments have a higher impact on your score than closed accounts with a positive history.
But if you made on-time payments throughout the course of your loan, the positive impacts on your credit history are highly likely to outweigh the marginal negatives of having the loan closed if it’s paid off on time.
A high credit utilization ratio is pretty damaging to your credit score.
Your credit utilization makes up 30% of your credit score. The only thing that’s more important is your payment history.
It’s not just how your utilization rate affects your credit score or the rates you’re offered, either. Most lenders will also add up your total debt payments and measure them against your current income. A high debt-to-income ratio could prevent you from getting a loan altogether, even if you’re happy with your credit score.
What if my credit utilization is 0%? Is that a good thing?
While that $0 balance on the Home Depot credit card isn’t hurting you in the above example, if all of your credit card balances were $0, you could generally expect to see a negative impact on your credit score.
So letting at least some debt show on your billing statement isn’t necessarily a bad thing, as long as you’re paying it off by the due date. The idea is that you have to actually use credit to prove that you can manage it. If you can do so while keeping your credit utilization rate under 30%, all the better.
TIP: If you don’t use your credit card for a long time, the bank may automatically close your account, which could lower your credit utilization rate. Making a small purchase every once in a while helps ensure that your accounts stay open, even if you don’t “need” to borrow to afford your purchase.