What are credit utilization ratios?

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Also called a utilization ratio, the credit utilization ratio is a metric used to calculate a borrower’s debt load, particularly with regards to lines of credit and credit cards. It is also a common input used in determining an individual’s credit score.

Calculating the credit utilization ratio

Measuring a person’s credit utilization ratio is fairly easy: it is the total amount of outstanding balances that a person has on all of his or her credit lines divided by the total of each credit account’s credit limit. The credit utilization ratio is expressed as a percentage. This ratio is oftentimes simply referred to as the “utilization ratio.”

For example, if an individual possesses a total credit limit on his or her credit cards of $10,000 and they have a total outstanding balance amount of $4,000, then they will have a credit utilization ratio of 40 percent. ($4,000 divided by $10,000 = 40%).

Effect on credit rating

Credit scoring programs, such as the FICO credit score model, often take the credit utilization ratio into consideration in two ways:

  • Individual accounts. The first method is by scoring the individual’s credit utilization on each of his or her credit cards separately.
  • Cumulative ratio. Second, the person’s overall credit usage, all credit balances combined, will be rated against the total credit limit on all credit cards held by an individual.

The net effect is that maintaining a higher credit utilization ratio will lower a person’s credit score, while lowering the credit utilization ratio will help to increase a person’s credit score.

With this in mind, consumers should always think twice before closing a credit card account, especially one with little or no fees. In fact, closing a credit card with good payment history and significant credit limits can often result in a lower credit score for the following reasons:

  • Increases credit utilization ratio. Closing a credit card or line of credit will lower a person’s overall credit limit. So unless the overall credit balance is significantly reduced as well, that person’s credit utilization ratio will rise because of the lower credit limits.
  • Removes an active account. Credit scores put more weight on current accounts, and less weight on past accounts. While that credit card or credit line is still active, it can have a strong impact on a person’s credit score. Once it is closed, its effect begins to wane.

This is not to say that credit cards and lines of credit should never be closed. But if increasing credit scores is a priority, it’s important to understand how closing a credit line will affect scoring.

The credit utilization ratio is just one of the primary groups of factors that determine one’s credit score. The other major credit scoring criteria include payment history, age of credit and the number of credit inquiries.

In addition to its impact on credit scores, the credit utilization ratio also affects how credit and loan applications are sometimes underwritten. Some lenders and creditors will examine an applicant’s overall credit utilization ratio as part of that applicant’s debt-to-income ratio. Higher credit utilization means higher debt obligations, which can impact how much residual income the borrower will have to pay for new loans and credit cards.

It is important to note that credit limits do not always show up on credit reports. If this is the case, an individual may need to check the field titled “High Balance” and use that figure instead of the missing amount of credit limit.

Options for reducing the credit utilization ratio

Several options are available for most individuals who wish to lower their overall credit utilization ratio. These are four of the most commonly used methods:

  • Pay down the debt. Arguably the best method for lowering one’s credit utilization ratio is to simply focus on lower the balance on all credit cards, lines of credit and other revolving debt.
  • Increasing existing credit limits. If paying down one’s debt will not produce results quickly enough, another option is to contact each creditor about increasing one’s credit limits.
  • Adding credit limits. Another way to increase one’s overall credit limit is to obtain additional revolving accounts – but not using them! This will increase a person’s total credit limit. Before taking this important step, however, it’s important to fully examine the terms of the new account and consult with a financial advisor.
  • Refinancing revolving debts. Another option is to use a personal loan or other installment loan product to pay down credit card debts. By turning a revolving debt into an installment debt, that amount is no longer factored into the credit utilization ratio. However, this also means obligating one’s self to an installment plan. Before using this approach, consumers need to examine the full cost of the new loan and consult with a financial advisor.

Disclaimer: NetCredit is a direct personal loan provider and does not provide financial advice, nor does it vouch for any vendor or service mentioned on our NetCredit personal finance blog or online consumer loan glossary. Always research and perform due diligence on any service provider or vendor before deciding to use them, and we recommend that you speak with a financial advisor regarding all decisions that will affect your finances.

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