We recently discussed the sheer volume of terminology inundating the world of personal finance – and now we’re on a mission to bring some clarity to the terms and phrases you may hear on a daily basis. Today’s term?
“Credit Utilization Rate”
Simply put, your credit utilization rate is the amount of credit you’re using based on what’s available to you. For example, if you have a $2,000 balance on a credit card with a credit limit of $10,000, then your credit utilization rate for that card is 20%.
However, it’s not just the credit utilization of one card that matters – what matters is your overall credit utilization. This number makes up 30% of your credit score and more or less “tells” lenders how responsible they can expect you to be with new credit. That’s just one of many reasons why it’s so important to monitor your credit utilization rate.
How to Calculate Your Credit Utilization Rate
Calculating your credit utilization rate is pretty simple. All you have to do is divide the balance you owe on a credit card with that card’s credit limit. That’s your individual credit utilization rate for that card. Then take all of your credit cards and add the balances and the credit limits. Divide total balance by the total credit limit. That’s your overall credit utilization rate, the one that gets factored into your credit score.
It’s important to note that installment loans (such as a student loan and a mortgage) can also be included in this, but are not factored nearly as heavily as revolving accounts like credit cards. The reason for this is because installment loans don’t offer more credit for you to borrow from. However, you can calculate their credit utilization rate on installment loans by dividing the current balance by the original balance.
Credit Utilization and Your Credit Score – and Your Debt
If your number one focus is to increase your credit score (likely if you’re thinking of buying a home or a car), then you’ll want to find the account that has the highest credit utilization rate and pay it off first (while still making minimum payments on your other accounts).
Caveat: Although paying off the account with the highest credit utilization first can help you increase your credit score faster, the downfall is that it could cost your more money.
Why? Because that’s not necessarily the account that has the highest interest rate. The account with the highest interest rate is the one that costs you the most money each day – and that allows more of your money to get sucked up by interest rather than going to your balance.
So, if your focus is to pay your debt off as fast as possible, don’t worry about your credit score just yet and instead pay off the highest interest rate account first. Besides, paying off any of your accounts will give your credit score an instant boost anyway – as long as you keep the account open and don’t use it.
Note: It is possible that your individual credit utilization rates are all equal or close to equal to each other. If that’s the case, focus on targeting your highest interest rate account first so you can pay your debt off faster.
How Your Credit Utilization Can Change – Unbeknownst to You
I mentioned above that it’s important to monitor your credit utilization rate. Part of this is because it can be motivating. As you pay off your debt, your credit utilization will go down and your credit score will increase in turn. Pretty great way to see the impact of paying off debt!
But, that’s not the only reason you’ll want to monitor your credit utilization…
Your credit utilization can suddenly change – unbeknownst to you.
Ever since the Great Recession, banks and lenders tightened up the reins on lending to prevent further loss. One result of this new conservative behavior was a desire to lower credit limits. However, consumers didn’t always know that their credit limits were being lowered (or why).
While much of the economy has recovered since then, your credit card company can still suddenly lower your credit limit. This will cause a jump in your credit utilization rate and have an immediate impact on your credit score.
If this happens to you, call your bank and ask them why. Then ask if they’ll raise it back up. Unfortunately, they may require a credit check to do so – so this might only be a good method if you know your credit score is high enough to get approved.
What’s the Ideal Credit Utilization Rate
As you think about all of this, you might be wondering what exactly your credit utilization rate should be. Unfortunately, there’s no clearly delineated answer to this question. However, financial experts commonly say it should be no higher than 30%. But to have the ideal credit utilization rate, many experts say to keep it at 9% or less.
If you’re deep in debt, the credit utilization rate can be frightening. After all, digging out of debt is difficult enough without also worrying about what it’s doing to your credit score. Try to ease your worries a bit for now. It’s far more important to pay off your debt than to lose sleep over your credit score.
In the end, it’s best to focus on making all of your payments on time – another large factor in your credit score. And then, as you get closer to reaching debt freedom, your credit score will inevitably go up – giving you the best of both worlds.
Image Credit: Alex Proimos