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What is Credit Utilization?

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Credit utilization is one of the most important components of your credit score, a three digit number that is increasingly becoming one of the most important numbers in your life. Credit utilization refers to how much you are using your available credit. Take your total credit balances, divide it by your total credit limit, and the percentage is known as your credit utilization.

Simple right? So why is it so important?

This post is part of the Bargaineering Annual Financial Review week series where we take a closer look at the four major facets of personal finance and see if we can do better. This post is part of day two – reviewing and optimizing your relationship with credit.

Why Credit Utilization is Important

Fair Isaac Corporation, the creator of the FICO credit score, broadly defines their equation as having five pieces: payment history (35%), amounts owed (30%), length of credit history (15%), new credit (10%), and types of credit used (10%). Credit utilization is just the fancy pants name of a component of that “amounts owed” category that accounts for 30% of your score.

Logically, this makes sense though. Put yourself in the creditor’s shoes, who is riskier: a person with a high credit utilization or a person with a low credit utilization? Obviously the person with a higher utilization because they are “close to the brink.” The person with a lower utilization will have a better credit score.

How does this affect you?

This is important because in our current economic climate, with impending credit card legislation, credit card companies are looking to cut down on their risk. People like you and me might be thinking about cutting down on our risk as well, chopping up a few credit cards in the process. Credit utilization affects you because when you cancel a card, or when a company cancels it on you, your credit utilization will go up – you will look riskier even though nothing changed.

There are ways you can minimize the impact of canceling a credit card, things you should do now if a company hasn’t given you the axe, but in the end your utilization will still be affected.

Finally, if you pay off your balances each month, utilization still affects you. Credit card companies report statement balances each month as the current balance on the card. You can pay it off but the balance is still reported and your utilization is calculated based on that number, even if you’ll be paying it down to $0 the next day.

I hope that partly demystifies some of the advice out there about canceling credit cards and how it affects your credit score. If I was unclear or missed an important point, please leave a comment so we can get this right. Thanks!

(Photo: andresrueda)

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29 Responses to “What is Credit Utilization?”

  1. redivelli says:

    With all of the credit problems recently I have come to find out that some of my limits have been lowered. How often is this reported to the credit agencies to update the total limit? I would imagine a monthly basis to be consistent with the balance stuff.

    There is a site called Credit Report Card (or something like that…) where is gives you a “grade” based on the categories of your credit report.

    Here is my main question. What cap would you say to put on available credit? My limit on my cards are 500 and 8500 (Dropped from 1500 and 10000). Is 30,000 a good cap? I think that is what my dad’s is at…

    • Jim says:

      Yes, it’s updated on a monthly basis.

      As for a cap, I don’t know what a good limit is. You want to keep utilization under 50% and probably under 20% if you can manage it. To do that, you’ll have to increase the limit or decrease your spending, so adjust accordingly.

  2. jsbrendog says:

    so then having a higher limit is good esp if you are not close to reaching it. The question then is to ask if it is a hard or soft inquiry when you request the increase, right?

    • Jim says:

      Yes, that is the question, usually if you can get it through an automated request, it’ll be soft. If you have to provide more information or talk to someone, it’ll be a hard. When in doubt, ask the CSR.

  3. dmeanea says:

    “Put yourself in the creditor’s shoes, who is riskier: a person with a high credit utilization or a person with a low credit utilization? Obviously the person with a lower utilization because they aren’t “close to the brink.””

    You may need to fix that paragraph, Jim. Unless I’m misreading, you meant “who is LESS risky:”.

  4. hoht says:

    So I was curious, I’ve been hearing from different perspectives as to whether or not I should pay off my credit card in full or carry over a small balance every month. What do you guys think is better?

    • saladdin says:

      Funny stuff.

      saladdin

      • lostAnnfound says:

        Pay it off. Why carry a small balance every month?

        • daenyll says:

          definitely pay it off, why carry a balance from month to month and end up paying more than just pay what you used each month and keep the interest they’d charge you for yourself?

          • NateUVM says:

            Pay it off. Carrying a balance is outdated advice that was based on misinformation and was when carrying at least some revolving debt wasn’t seen as being so detrimental to one’s overall financial health.

    • Jim says:

      Always pay it off, your balance is reported before the payment so you get “credit” for having the balance and paying it off. You get no added benefit by paying interest.

      • hoht says:

        Ah, okay because I was getting ambiguous answers from my credit union. Some people said pay off every month and others said carry a small balance every month.

        • hoht says:

          Thanks guys! :D

          • saladdin says:

            Sorry dude.I thought you were being sarcastic.

            Your credit report can still show a balance reported based on when you cc company reports and when you pay. Mine does all the time. Remember, a portion of your score is utilization. If you utilize more your score suffers so carrying a balance can hurt.

            saladdin

        • Jim says:

          Only credit card companies want you to carry a small balance. :)

  5. Anthony says:

    @hoht: I hear these things all of the time. Why carry a balance?

    More importantly, I know your credit score is an overly important 3-digit number, but some go into debt trying to improve your score!

    Someone once told me that carrying 20% to 30% of your limit is ideal. Umm no, it’s ideal if I pay it off every month!

    • saladdin says:

      I know some people who get a small loan every few years just to add a new tag line. It is possible for this to help but you would be paying ( through interest) for a FICO score. Not a good trade off for me.

      saladdin

      • Jim says:

        I don’t think getting a small loan just for the purposes of improving your score makes sense. After a certain point, your score is “good enough.” Why pay interest to get it marginally better?

      • Saladdin–that advice is more for people who are trying to develop their credit. Once you have an established credit profile, having too many accounts can work against you.

        There’s much talk about credit utilization, but another component of credit scores is number of accounts open. Too many is a negative. Better a few well managed accounts than 15 pages of open but inactive accounts.

  6. It’s definitely advantageous to credit card companies and banking institutions to suck as much interest from their customers as possible. There’s nothing in it, credit or benefit wise, for the consumer.

    Credit utilization is an often forgotten component of our credit scores. This post serves as a great reminder of that.

  7. eric says:

    Good post…lots of people are confused about credit utilization, especially when it pertains to canceling cards and such. Helps demystifies the subject!

  8. aua868s says:

    i was under the impression that no matter what my credit utilization is, as long as i pay my balances in full and on time my credit score would not be hit…thanks for the eye-opener.

    • saladdin says:

      Nope. I have a $1000 limit card. I charge that to max every month but pay it off. I have not paid cc interest in 15 years. But they report balances before my payment hits my account so in my credit report it looks like I have 1000 charged on a 1000 limit which hurts my score.

      It’s a timing thing.

      saladdin

      • NateUVM says:

        @ saladdin – Have you tried to get an increase in your credit limit? Are you in a position to request one? Or, is it a way that you have found to self-regulate your expenses? Would you just spend to your new maximum if your credit limit were to increase?

        Just curious. $1,000 limit seemed overly restrictive, in your case.

  9. otipoby says:

    Another option to lower your credit utilization is to pay off the balance twice a month (or more). This way, you can use your cards, payoff every month, and still have low utilization.

  10. Chris says:

    I run all monthly expenses through my rewards card and make a few payments a month to try to keep the balance low. Delicate dance of credit utilization vs available credit.

  11. usaama says:

    Thanks for the post! Very useful info.

    Just one thing though: if i pay off my debt before the end of the month so that my balance actually says zero, is my credit utilization still going to be high? Eg, if i use $500 on the first day of the month, buy go online to my credit card account, and pay back $300 a week later, several weeks before i get my bill. And then i get a bill of 200 at the end of the month, how is my credit score affected? What if i pay the entire bill early so that my bill is actually $0, is this good, bad, or neutral for my score?

    Thanks!


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