What is Credit Utilization Ratio?
The credit utilization ratio, also known as the balance-to-limit ratio, compares the amount of credit used versus the total available credit. The ratio outlines how well an individual is managing their credit and is used by consumer credit reporting agencies such as TransUnion and Equifax as part of their process of determining the credit score of an individual.
Formula for Credit Utilization Ratio
- Used Credit refers to the amount of credit outstanding; and
- Available Credit refers to the total amount of available (authorized) credit.
Consider an individual with the following spending habits on his credit card:
The individual’s credit utilization ratio for each month is calculated as:
- $500 / $1,500 x 100 = 33% in January;
- $254 / $1,500 x 100 = 17% in February; and
- $765 / $1,500 x 100 = 51% in March.
Importance of Credit Utilization Ratio
The credit utilization ratio is commonly used by consumer credit reporting agencies as part of their credit score rating process for consumers. A ratio that is too high negatively impacts the credit score of an individual. According to Experian, it is recommended to keep the ratio below 30%.
A low ratio implies that an individual is doing a good job managing his or her credit. On the other hand, a high ratio may be a red flag that the individual is not managing their credit well.
How to Improve a Credit Utilization Ratio
1. Request a credit line increase
If an individual is constantly above the benchmark 30% credit utilization ratio, the individual should ask their credit card issuer to increase the available credit limit. In doing so, the denominator in the ratio would increase and effectively decrease ratio (assuming the amount of credit used remains the same).
For example, consider an individual with a used credit of $1,000 and a credit limit of $2,000. It would imply that the ratio is 50%. If the individual can increase the limit to $2,500 and maintain the amount of used credit, the ratio would now be 40%.
2. Use additional credit cards
Although not recommended for an individual with poor credit management capabilities, using additional credit cards can lower the credit utilization ratio.
For example, consider an individual with a used credit of $1,000 and a credit limit of $2,000. It would imply that the credit utilization rate is 50%. However, if the individual can use an additional credit card and spend $500 on each, he would achieve a ratio of 25% on both cards.
3. Setting up balance alerts
If an individual finds it difficult to manage their credit, it would be effective to set up balance alerts. Setting up the alerts can usually be done by contacting the credit card issuer.
For example, an individual can sign up with their card issuer to receive alerts via text message or email when the credit utilization ratio reaches a certain point (30%, 50%, 70%, etc.).
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful: