Everyone knows about credit card limits. They're the amount that you're able to spend each month without being charged extra fees or getting your card declined. Most people know their credit card limit (and if you don't, it's easy to find out). But there's a similarly important number when it comes to credit, and most people aren't paying attention to it.
It's your credit utilization ratio -- that is, the amount of credit you're using divided by the amount you have available to you. For example, if you have a $10,000 credit limit and you spend $5,000 of it, then you're at 50% credit utilization. Is that a good number or a bad one? Most people wouldn't know, but it's important to find out. Your credit score depends on it.
What's a good credit utilization ratio, and why does it matter?
Your credit utilization ratio serves as an indication of your financial stability, and a high ratio may indicate that you're living beyond your means. Your credit utilization ratio makes up 30% of your FICO score equation, so it's no small matter. FICO scores are the ones most commonly used by lenders to determine your creditworthiness, and a low score may prevent you from getting a loan or securing an affordable interest rate.
An often-cited rule is to keep your credit utilization ratio under 30%. This is cumulative across all of your credit accounts, so add up all of your credit limits on all of the accounts you have and multiply by 0.3. That should be your self-imposed credit limit if you're trying to keep your score high. And if you can keep the amount you borrow even lower, all the better. According to FICO data, the people with the highest credit scores tend to have credit utilization ratios of 6% or less.
If you exceed the suggested 30% limit, you can expect your credit score to take a hit. The amount it will decrease by will depend on how high your ratio is and where your credit score was to start with. It's not uncommon for those with credit scores over 700 to lose 40 or 50 points off of their scores once their credit utilization ratio begins to climb over 50%.
How to fix a bad credit utilization ratio
If you've done the math and found out you're using a much higher percentage of your credit than you should, there are a few ways you can fix this. The first is to cut back on your credit card use. Pay with cash or a debit card instead or just cut back on your spending, period.
Another option is to try to increase your credit limit. You can do so on your card issuer's website or by contacting the company directly by phone. This is only a good idea if you feel confident that you'll be approved, though. Every time you apply for a new card or a credit limit increase, the issuer will do a hard pull on your credit reports. This will cause your credit score to take a slight hit, although the penalty won't be nearly as severe as with maintaining a high credit utilization ratio. If you're going to apply for more than one credit limit increase, it's best to do them as close together as possible. Credit scoring models usually count all hard inquiries that occur within a one-month period as a single inquiry.
If you absolutely cannot cut your credit card usage, and you haven't had any luck with credit limit increases, then you may want to think about paying your bills twice per month. This way, you're able to spend more of your available credit while still keeping your credit utilization ratio low.
Say you have a credit card with a $10,000 limit, but you anticipate spending about $6,000 of that limit this month. If you pay it off in a single payment at the end of the month, your credit utilization ratio will be 60%. But if you make a mid-month payment after you spend $3,000 and then pay the remaining $3,000 when your normal bill comes due, then the credit bureaus will only see your $3,000 balance. That's because card issuers usually only report your balance to card issuers on your closing date. Any amount that has been paid off before then is usually not counted toward your credit score.
Being mindful of your credit utilization can go a long way toward improving a poor credit score or keeping a good credit score high. Do a periodic review to ensure that you're keeping your credit usage under 30%, and look for ways to cut it back even further.
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