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Credit scores are a 3-digit number between 300-900 that is used by lenders to determine you’re likeliness to repay a loan or bill. Credit scores are calculated based on the information your lenders, collection agencies and other sources report to the credit bureaus. However, in general, there are five main factors that are used to calculate your credit scores, a major one being the credit utilization ratio.
What Is A Credit Utilization Ratio?
A credit utilization ratio, otherwise known as the debt to credit ratio, represents the amount of revolving credit you’ve used versus the amount you have available to you. Revolving credits including accounts such as your credit cards and lines of credit.
What Is A Revolving Credit?
Revolving credits are products that do not have any fixed payments. Credit cards and lines of credit are two types of products that fall under this category. With both products, you’ll have access to a certain credit limit which you can use as much or as little as you need. The funds you use become accessible again as you repay the balance.
Debt To Credit Ratio vs. Debt-To-Income Ratio
- Debt-to-Income Ratio – A debt-to-income ratio involves looking at your monthly debts versus your monthly income. This ratio is typically used by lenders when assessing you for loan approval and it has no impact on your credit scores.
- Debt to Credit Ratio – A debt to income ratio involves looking at your revolving credit usage versus your available credit limit. This is a common factor used when calculating credit scores and typically accounts for around 30% of your credit scores.
Is There A Perfect Credit Utilization Ratio (Debt To Credit Ratio)?
Typically, lenders and creditors like to see a credit utilization ratio of 30% or lower. However, keep in mind that “perfect” is subjective and ambiguous when it comes to personal finance and credit scores. Everyone’s personal finance needs are unique, so you should aim to find a credit utilization ratio that suits your financial situation. Also, your credit utilization ratio becomes more important when you’re applying for new loans or credit, it’s not entirely necessary to keep your credit utilization ratio at 30% all the time.
How To Calculate Your Credit Utilization Ratio (Debt To Credit Ratio)?
Credit utilization ratios are very simple to calculate as it is merely a percentage calculation, the two steps are discussed below.
- Find your current balance owed and credit limit. You can find this information on your most recent credit card statements. Alternatively, you can log into your bank account and obtain the most current information. If you can’t find this information, give your bank a call for assistance.
- Calculated Your Credit Utilization Ratio – The formula for credit utilization ratios is [current balance/credit limit]. Divide the current balance owed by the credit limit. You can then multiply by 100 to get a percentage.
To help demonstrate the credit utilization ratio calculation, below is an example.
Example 1: Single Credit Card Calculation
If you only have one credit card and the balance is $400 and your credit limit is $1,000, you can calculate the ratio by dividing the balance ($400) by the credit limit ($1,000). The ratio you get is 0.4 or 40 percent if you multiply by 100.
Example 2 : Multiple Credit Card Calculation
Let’s say that you have two credit cards, one has a balance of $800 and a limit of $1,000 and the other has a balance of $600 and a limit of $1,500. To calculate your ratio, follow these steps:
- Add the total current balances of both your credit cards. This will give you $1,400 for the current balance.
- Add both your credit limits. This should equal 2,500 based on our example.
- From there, you can calculate the credit utilization ratio by dividing the current balance by the credit limit. This will give you a ratio of 0.56 or a percentage of 56% if you multiply by 100.
Does The Debt To Credit Ratio Affect Credit Scores?
Credit scores are calculated using the information reported to the credit bureaus by your lenders, creditors, collections agencies and other sources. In general, there are 5 main factors used:
- Payment History – Usually accounts for around 35% of credit scores
- Credit Utilization Ratio – Usually accounts for around 30% of credit scores
- Credit History – Usually accounts for around 15% of credit scores
- New Inquiries – Usually accounts for around 10% of credit scores
- Public Records – Usually accounts for around 10% of credit scores
As you can see from this list, credit utilization ratios are one of the more important factors when calculating credit scores. However, depending on the credit scoring model used, it may carry more or less weight, which may affect its impact on the credit scores. Broadly speaking, high debt to credit ratios can have a negative impact on your credit scores, while low debt to credit ratios may have a positive impact.
How To Improve Your Credit Utilization Ratio
Before making changes to your credit utilization ratio, keep in mind that your credit card information is not updated in real-time on your credit report. Usually, credit card information is updated on your credit report when the respective billing cycle ends. Once the billing cycle ends, your credit issuer will send the ending balance to the credit bureau, at that point, it will be updated on your credit report. This means that you won’t see any changes you make to your credit utilization ratio on your credit report instantaneously.
Bettering your credit utilization ratio means lowering it, you can do so using the tips and tricks below.
Increase Credit Card Limits
By increasing your credit limit, but keeping your spending the same, your credit utilization ratio will become lower. It’s important to note that a credit bureau can penalize you for increasing your limit as it may indicate an urgent need for funds. Although, this is a short-term consequence so long as you continue to manage your credit well moving forward.
Be Mindful Of Balances
The most obvious thing you can do is keep an eye on balances and avoid going over a certain limit. It’s also possible to set up balance alerts with your bank so you’re notified when the balance goes over a certain amount.
Credit Card Billing Cycles
Since credit card information is updated on your credit report at the end of a billing cycle, try your best to keep the balance low at the end of a period. This way the balance that shows up on your credit report will be lower, regardless of the activity that went on during the billing cycle.
Pay Your Credit Card Twice A Month
By paying your credit card twice a month, you will be keeping your balance lower regardless of how much activity you have on your card. This method is one of the easiest ways to keep your credit utilization ratio low.
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Credit scores are an important part of our financial profile and it can help open doors to different credit products. While your credit utilization ratio is a common factor used to calculate your credit scores, implementing extreme and stringent measures to keep your credit utilization ratio low isn’t necessary at all times. It’s best to find a healthy balance between taking advantage of credit card products and using them responsibly.
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