What is a Credit Utilization Ratio?
How Does a Credit Utilization Ratio Work?
The formula for credit utilization ratio is:
Let's say you have three credit cards. One has a credit limit of $500, another has a credit limit of $1,000 and the third has a credit limit of $2,000. Let's also assume you carry a debt balance on all three cards. The three card balances combine to $1,000.
Total Debt Balance = $1,000
Total Available Credit = $500 + $1,000 + $2,000 = $3,500
By plugging these two factors into the formula, we can find the credit utilization ratio:
Credit Utilization Ratio = ($1,000) / ($3,500) = .2857 = 28.57%
In this case, your credit utilization ratio is 28.57%. Looked at another way, this would mean that you are using 28.57% of your available credit limit.
Why Does a Credit Utilization Ratio Matter?
Your credit utilization ratio tells potential lenders how much debt you are carrying and how much of your available credit you are using. The lower your credit utilization ratio, the more favorable it looks to lenders (and the higher your credit score) because it's more likely that you'll be able to make payments on your debt.
Someone with a high credit utilization ratio carries a lot of debt or is nearing their maximum credit limit, which looks risky to lenders because they may be less able to repay debt.
About 30% of your credit score is calculated using the credit utilization ratio, so if you're serious about raising your credit score, try to keep a low credit utilization ratio by paying off excessive debt.
[For more credit building tips, see 7 Steps to Perfect Credit]