What is a Utilization Ratio?
The utilization ratio compares an individual's total debt balances to total available credit. It helps determine part of a person's credit score.
How Does a Utilization Ratio Work?
The utilization ratio is also called the credit utilization ratio.
The formula used to find utilization ratio is as follows:
Utilization Ratio = (Total Debt Balance) / (Total Available Credit)
Assume you have three credit cards. One has a credit limit of $500, the second has a credit limit of $1,000 and the third has a credit limit of $2,000. We also assume that you carry a debt balance on all three cards. The three card debt balances combined make up a total debt balance of $1,000.
Total Debt Balance = $1,000
Total Available Credit = $3,500 (or $500 + $1,000 + $2,000)
Putting these two factors into the formula, we can find the utilization ratio:
Utilization Ratio = ($1,000) / ($3,500) = .2857 = 28.57%
In this example, your 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 Utilization Ratio Matter?
Your utilization ratio tells potential lenders how much debt you owe and how much of your available credit you are using. The lower your utilization ratio, the better it looks to lenders (and the higher your credit score will be) because it's more likely that you'll be able to make your payments.
Someone with a high utilization ratio often carries a lot of debt or is nearing their maximum credit limit. This looks risky to lenders because that person may be less able to repay them as the debt builds.
About 30% of your credit score is calculated using the utilization ratio. If you would like to raise your credit score, you should keep a low utilization ratio by paying off excessive debt.
[For more credit building tips, see 7 Steps to Perfect Credit]
