What is a Credit Utilization Ratio?

By Gabriel Wood, NextAdvisor.com

When many people think of their credit scores, the first thing that comes to mind is their payment history. However, while payment history is the primary component of your credit scores, it isn’t the whole picture. There’s another piece, called credit utilization ratio, that plays a big part in determining how you measure up in the eyes of creditors. More importantly your credit utilization ratio is something you have control of right now. Read on to learn how credit utilization ratio works, as well as what steps you can take to improve yours.

What is a credit utilization ratio?

Credit utilization ratio is the amount of credit you are using compared to your credit limit, expressed as a percentage. For example, if you have a credit limit of $1,000, and you are carrying a credit card balance of $200, your credit utilization ratio is 20% because $200 is 20% of $1,000. Your credit utilization ratio is a key part of your debt burden (or the amounts owed aspect of your credit scores), which makes up 30% of the FICO score. To give you some perspective, that’s only slightly less important than the No. 1 piece of the FICO score, payment history, which makes up 35%.

What makes credit utilization ratio special is that it’s one of the only parts of your credit scores that you can improve quickly. Other parts, like your payment history and the length of your credit history, take a long time to build up, but you can significantly boost your credit utilization ratio in only a month or so.

How do I improve my credit utilization ratio?

The lower your credit utilization ratio is, the better your credit scores will be. A good ratio to shoot for is around 30%, not only across all of your accounts in total, but on each individual account as well, as credit scores take both of these factors into consideration. If you can get your ratio lower, that’s even better, but make sure you don’t go down to a 0% total utilization ratio because FICO takes this as a sign that you aren’t using any forms of credit, which will damage your credit scores. Mathematically, there are two ways to lower your credit utilization ratio. Either you can pay off your credit accounts and decrease your credit balance, or you can increase your credit limit.

Decrease balance: According to FICO, credit utilization ratio is an excellent indicator of how creditworthy a person will be in the near future, and higher utilization ratios are generally associated with a greater risk of a person not being able to pay their credit card bills. Carrying a high balance on your credit accounts relative to your credit limit makes you look like a risky borrower, even if you know you can pay that balance off. To make sure your balance goes down, pay your credit card off several times a month, instead of just once. You could also call your credit issuers and ask what time of the month it reports your account information to the credit bureaus, then pay off your account a few days before that to ensure your issuer reports your balance as low. Even if you have trouble paying off your credit accounts completely, just decreasing your balance will improve your credit scores at least a little bit.

Increase limit: Increasing your credit limit is also an effective way to decrease your credit utilization ratio, however, you have to be careful. Raising your credit limit only improves your scores if your credit account balance doesn’t go up with it, so if you go this route, it’s important to control your spending habits. Additionally, increasing your limit is not as easy as just opening up a new credit card. While the latter will boost your total available credit, your scores also factor in how many credit accounts you have in total as well as how new your accounts are, so any boost to your scores from an improved credit utilization ratio will likely be canceled out by the hard inquiry, along with any other potential negative factors (e.g., too many revolving credit accounts) that may come with opening a new credit card. The more effective approach is to increase the credit limit on accounts you already have by talking with your credit issuers. Just make sure the credit limit increase doesn’t come with a hard inquiry to your credit reports, or else you’ll get a few points knocked off your scores — note that if you get a significant credit limit increase, the hard inquiry may not matter.

If you’re looking to increase your credit scores even further, another quick way to add points to your scores is to have derogatory items removed from your credit reports. Of course, you’ll need to check your credit reports before you can do this. Federal law entitles you to one free copy of all three credit reports (Experian, Equifax and TransUnion) once every 12 months through AnnualCreditReport.com — be aware that you’ll have to pay a fee to view all three credit scores. If you’ve already checked your credit reports this year (and you’re not eligible for another free copy) or you want a way to keep tabs of your credit for an extended period of time, you may want to consider signing up for a credit monitoring service. Most of these services will not only provide you with all three of your credit reports and scores upon signup, but also alert you if anything is added or changed on any of your three credit reports, a handy feature to have after the Equifax breach. Once you have a copy of your credit reports, make sure you look through them to confirm there are no errors. If you find anything amiss, you can either report the errors yourself, or hire a credit repair service to do all the legwork for you.

Credit is a confusing topic, but understanding the basics, like your credit utilization ratio, can help you get more in touch with your credit and how it functions. For more tips on how to build your credit scores and live a financially healthy life, follow our credit monitoring blog.

This blog post originally appeared on NextAdvisor.com.