Everyone probably knows what a credit score is, but most have no idea why they have the score they do.
It’s pretty intuitive that if you don’t pay your bills on time or find yourself in bankruptcy, foreclosure, or in other serious default with your creditors, your credit score will plummet. However, there are millions of Americans who pay all of their bills on time (and always have) and still have a crummy credit score.
If this is you, it could be the result of high credit utilization.
Wait, wait… I know what you’re going to say. I get it all the time.
What the heck is credit utilization?
Definition of Credit Utilization
Here’s a simple definition: Credit utilization is how much credit you are using (i.e. balance) compared to how much credit you have available (i.e. credit limit).
For example, if you have a balance (i.e. outstanding charges) of $1,250 on a credit card with a $5,000 credit limit, then you have a credit utilization of 25 percent.
($1,250 / $5,000) x 100 = 25%
How Does Credit Utilization Affect My Credit Score?
Regardless of the credit scoring model your lender is using, most weigh credit utilization as a significant factor in your overall score. For example, both FICO and the Quizzle credit score base approximately 30 percent of your score on “amounts owed,” which includes credit utilization.
This is second only to your payment history in importance to your overall credit score.
Why is Credit Utilization So Important?
Ultimately, creditors use your credit score to determine their risk in lending you money. If you’re already maxing out all of your available credit, most creditors are going to be a little leery of giving you additional credit lines or loans.
Credit utilization can also become a silent killer on your credit report if you don’t keep a close watch.
[Speaking of... when was the last time you checked your credit report? Get a free credit report and score from Quizzle.com.]
In the current economy, credit card companies are actively managing their risk. Many credit card companies are canceling credit cards if you are not using them or if you have a sudden drop in your credit score.
[Free Resource: Check your free credit report and score]For example, if you have two credit cards, each with a $1,000 credit limit, your total available credit is $2,000. If you have charged $500 on one of the credit cards and paid off the other, then your total credit utilization is 25 percent.
However, if you or your credit card company close that unused credit card, your available credit suddenly drops from $2,000 to $1,000, and that $500 balance now soars your credit utilization to a whopping 50 percent – killing your credit score.
This is just another great reason to keep regular tabs on your credit report.
What is Good Credit Utilization?
This begs the question, “What is a good credit utilization?”
There’s no exact answer to this question, but I can give you some simple guidelines.
It’s generally accepted that keeping your total credit utilization under 30 percent will keep your credit score in the good range. Reducing your credit utilization to 10 percent will more than likely put you into the excellent credit score range, assuming all other factors are strong.
Also, keep in mind that you should avoid any single credit card climbing above these ratios too. Doing so may also ding your credit score.
Credit utilization is very important, but can be confusing. Any questions?