What is Credit Utilization Ratio and Why is it important?

What is Credit Utilization Ratio and Why is it important?

Credit Utilization is one of the most important factors considered while calculating your credit score. Credit Utilization pertains to how you use revolving credit, mostly offered through credit cards. It is the ratio of the total credit card balance you have to the credit card limit and is calculated across all the credit cards you have.

How does Credit Utilization Ratio work?

The credit utilization ratio is typically focused primarily on a borrower’s revolving credit. It is a calculation that represents the total debt a borrower is utilizing compared to the full credit which is approved for the borrower.

It is important that the credit utilization ratio is kept below a certain limit. A high credit utilization ratio means that you are bad at managing your finances and cannot afford the lifestyle you lead. You are living your life on credit rather than based on your income. A low credit utilization ratio on the other hand reflects a sensible borrower who manages their income and expenses proportionality.  

How to calculate Credit Utilization Ratio?

To calculate your credit utilization ratio you need to tally all your credit accounts. Consider an example: say you have three credit cards with a joint credit limit (ceiling) of Rs. 1,50,000. On credit card A you have spent Rs. 30,000; on credit card B Rs. 20,000 and on credit card C you have spent zero. Your total outstanding across the three credit cards is Rs. 50,000. Your credit limit across all cards is Rs. 1,50,000. Therefore your credit utilization ratio would be calculated as follows:

150000/50000 * 100 = 30 %

This means your credit utilization ratio stands at 30%, meaning you have used up 30% of the credit allocated to you. This is a reasonably good credit utilization ratio.

How does Credit Utilization Ratio Affect my Credit Score?

Maintaining a low credit utilization ratio is crucial for a healthy credit score. A high ratio, indicates heavy credit card usage and can be seen as a red flag by lenders. It may suggest that you rely on credit too much to finance your lifestyle and are therefore considered a irresponsible borrower. A low ratio on the other hand suggests a person who is aware of ones income and credit allocated and uses it wisely. Credit bureaus utilize this ratio to assess your credit worthiness and take a decision on your loan amount and credit limit based on it.

Tips to Manage your Credit Utilization Ratio

Now that you are aware of what credit utilization ratio is and its importance, let us look at some ways you can keep it low:

  1. Spend within the limit- Just because your credit card or cards have a higher limit it does not mean you have to spend the entire limit. Always remember the 30-70 credit utilization ratio limit and try to keep your expenses within it. In case you have exceeded 30% on one credit card, try to balance it with your other credit cards. Do not use them at all or try to keep the expense on them at a minimum.
  2. Repay in full- Ensure that you pay your credit card bills in full every month. Remember if you pay your credit card payments in full every month, you are affecting your credit utilization ratio. Repaying the entire debt or making substantial payments every month will keep your credit utilization ratio in check. Even when you’re not making full payment, make sure to keep your outstanding dues as low as possible to achieve a low rate.
  3. Avoid using all your credit cards- Another way of keeping your credit utilization ratio low is to avoid using all the credit cards you own. This will automatically increase your credit limit thereby keeping your utilization ratio low. However you also need to be mindful about not overspending on one credit card. The overall ratio should remain at 30% or below.
  4. Increase credit limit- If you have a good credit history on your credit card and have been paying every month in full, for more than 6 months, you can request the card issuer to increase your credit limit. If this is approved, it increases your total available credit thus helping you to get a low usage rate, provided you don’t increase your expenditure on the card.
  5. Apply for new credit cards- This is tricky option but one can exercise it with caution. Opening a new credit card account to increase your total credit limit might have a short-term negative effect on your credit score.

The Bottom Line

Keeping your credit utilization ration low is one of the best things you can do for your credit score. Focus on both parts of your equation- the credit limit as well as balance. Always look to maintain a reasonable ratio or bring it down. While recovering from a late payment or due balance can take time but lowering your credit utilization ratio can immediately have a positive impact on your credit score.

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