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