How Credit Utilization Affects Your Credit Score
Credit score is one of the most important number. It shows your financial status. It tells you whether you are eligible for the credit card or for loan. It also tells you that how much interest you need to pay for buying different things like house, car or money. Your credit score tells the lender about your financial condition and about your previous loans status that how regular you pay your bills or debts. But keeping the score is high is a big deal. The credit score ranges from 300 – 850. Credit score above 700 is considered as good while below 600 is considered a bad credit score.
There are major five categories which are used to calculate your credit score. Each category has its effect on your credit score, each have its own importance. The categories are :
- Payment History : It accounts 35% of your credit account,based on how frequently you pay the bills.
- Credit Utilization : It tells about the debt you owe to the creditors and lenders, it makes up 30% of credit score.
- Length of Credit History: It makes 15% of your credit score and it tells that for how long you have had access to your credit.
- Credit Mix and Inquiries: It accounts around 10% of your credit score, it is basically diversity of the types of credit.
So the amount of debt you carry is the second important component of your credit score. The ratio of calculates the amount of your debts and credit card you have borrowed and then compare it with your credit limits.
It accounts that how much you owe from lenders, how much you owe from your credit card and how much you owe from your each account. The percentage of installments and potential of lack in certain loans.
Credit Utilization Calculation
This is one of the most important factor, credit mix just consider how much debts you have on revolving around, compared to the maximum amount you have allowed to the charge.
It is referred as credit utilization ratio, very simple and easy to get.
To calculate the credit utilization start by tallying up your all debts and then arrange your all credit limits. Now you have to divide the amount of debt by the credit limits and you have your credit utilization ratio.
Please note that credit utilization is calculated by calculating all your debts spread across through your spending limit.
Most of the time people think that when you pay off one credit card, your account is automatically close , but this is not true. This action can ruin your credit score very quickly. Because taking the entire line will actually increase the credit utilization ratio. Through this the result will be the exact opposite to the thing we want to do.
So what we can do? For example if you owe $1,000 and you have $5,000 in total credit limit. Let’s assume your each card’s limit is $2500 and your balance $1000 is on one card. And if you close your balance free card your credit limit will drop to $ 2,500.
That means instead of having 20% of credit utilization ratio will jumped upto 40%.- double to initial score! And it will results by dropping your credit score.
Revolving Debt v/s Installment Debt
When we are knowing credit utilization, it is important to understand the different types of debt you have on your credit report. So very first is revolving debts; like credit card and store card are weighted more negatively than loans installments such as student loan and auto loans.
There are several reasons for this. One is the installments loan like your house , car and collateral attached to them.
If you stop paying, the lenders can reclaim on the home or foreclose the car which make people to repay those loans before any other debt.
Where student loan don’t have collateral but they do indicate the lender that borrower might have higher capacity for earning potential overtime. So it has no collateral attached to it.
In this case lenders believes that you would less likely to pay because if you can in financial hardships you will have nothing to except your credit score. Some installments like mortgage, student loans are considered to be “good debt” because it add value to your return and net worth.
So when your credit score is calculated not only that how much debt you have but also what kind of debt you have is also considered. Knowing these facts could help you to focus on your loans and when you decide to pay off your debts.
Getting the best Credit Utilization Score
Now as you have the basic information now you need to figure out your credit utilization ratio.
Most credit experts recommend to not owe more than 30% of your credit limit. So if your credit limit is $5,000 you wouldn’t owe more than $1,500. And if you pay that amount within the month it is fine to charge that amount. However when you are applying for a credit card or loan it may well show your average balance even if you pay off regularly.
For this you can do two things either you stop using credit card for at least a month before or pay on your account multiple time. There are several techniques which you can use and increase your credit score rapidly.
Opening New lines of Credit
This is another trick of trade to lower your credit utilization score. As you know by adding extra credit card you will have higher overall limit.
And for each enquiry for new loan or new credit card will surely lower your credit score up to 5-10 points temporarily.
If you already have a lot of inquiries in your credit report then it will not show in favorable by lender. But if you don’t have hard inquiries in your credit report for last 2 years, getting a new credit card and using it responsibly could be in favor of your credit score.
The another way is to pay down the small credit bills first so that you clear an entire line of credit quickly.Finding your credit utilization ratio may seem formidable at first but paying down your debt is often the best way to improve your credit score.