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Navigate Your Credit Successfully

Neal Frankle
I’m Neal Frankle, Certified Financial Planner™. Credit problems are a serious business. In fact they changed my entire family life when I was 16. This site is here to help you repair your credit without getting ripped off. Read my story.
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Credit Utilization – How It Can Help You, How It Can Hurt You

by Neal Frankle, CFP®

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If you are working on boosting your credit score, you’ve undoubtedly heard the term “credit utilization”. But what is it, why is it so important, and how should you use it? Let’s take a look.

What is a Credit Utilization Ratio?

Credit utilization is expressed as a percentage – or ratio – of the amount of debt that you have outstanding, divided by the total amount of your credit lines.

For example, if you have $50,000 in total credit lines available, and you owe $25,000, your credit utilization ratio is 50% ($25,000 divided by $50,000) because you are using half of all the credit you have available.

Keep in mind that the ratio considers credit cards and home equity lines – not mortgages. Creditors like people who have low credit utilization because they are more liquid. They are more liquid because they have more credit and they can tap in to should they need to.

People with higher credit utilization are illiquid because they have already tapped into most of the credit they have available. This is frightening for creditors. People who have used up most of their credit have a much higher likelihood of running into problems if they lose their jobs or run into some other financial speed bump. If that happens and they run out of credit sources, those people won’t have the cash to pay their bills. This is what keeps creditors up at night and it’s why many won’t grant you credit if your utilization is too high.

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How Credit Utilization Affects Your Credit and Credit Score

Credit utilization is a hugh factor in determining your credit score by all three major credit bureaus – Equifax, Experian and TransUnion. Under the FICO scoring model that all three use, credit utilization represents 30% of your total credit score. It is second only to your payment history in determining your score, which represents 35% of your score.

A high credit utilization ratio can seriously weigh down your credit score, even if you have no delinquent credit. And beyond your credit score, some lenders may refuse to issue you new credit if your credit utilization is too high as I said. And this is often the case even if your payment history is perfect. A high credit utilization ratio is seen as a strong predictor of default, making lenders unwilling to extend fresh credit to you.

What’s a Good Credit Utilization Ratio? What is a Bad One?

As a rule, a credit utilization ratio of 30% or less has a positive impact on your credit score. As it rises above 30%, it begins to have a negative affect. The closer that the ratio moves to 100%, the worse your credit score will be.

It’s important to understand that since no two credit profiles are exactly alike, the specific affect of credit utilization will vary from one person to another. For example, one person may begin seeing a serious decline in credit score with a 50% credit utilization ratio, while another seems unaffected with a 70% ratio.

Still, you should strive to keep your credit utilization ratio as low as possible. This could be the difference between getting a loan in the future, or being declined. It can also have a major impact on the interest rates you’ll pay for a loan.  There are plenty of items you can be taken off your credit report fairly easily.  But if you’ve got a high credit utilization, the only way to fix that is to pay down some of that debt or refinance it.

How to Improve Your Credit Utilization Ratio

If a high credit utilization ratio is considered to be negative, then the best strategy is to pay your debts down steadily, so that the ratio improves. As it does, you should see your credit score rise.

You don’t necessarily have to set a specific credit utilization target – just the fact that you are lowering the ratio should mean you’ll experience gradual improvement. You can do this either by paying down your credit cards, or by paying a few off completely, if you are in position to do so. Sometimes, refinancing your debt can improve your ratio simply because private loans often aren’t even reported.

If you do pay your loans off, don’t close them out! Closing out credit lines will lower your available credit, which can easily result in an even higher credit utilization ratio. The idea is to payoff any balance that you owe, while keeping your credit lines open. This keeps the available credit high and the used credit low. Just the way you want it.

Credit utilization is the second most important factor in calculating your credit score. That means that even if you are paying all of your bills on time, if your credit utilization is considered to be excessive, you may still have a fair or even poor credit rating.

Your credit utilization is seen as a major predictor of future credit problems, which is why it weighs so heavily in calculating your credit score, and why lenders pay so much attention to it. That means, it’s something you should pay attention to as well.

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