For anyone looking to improve their credit rating, it pays to know the basics of how our FICO scores are calculated. Responsible payment history is a significant factor in determining your credit score, but what are some of the other elements involved?
Believe it or not, the second biggest influence on your credit score is something known as your credit utilization ratio. This is often thought of simply as the amount you owe, but in fact there’s a little more to it than that.
Your credit utilization ratio is calculated by dividing the outstanding balance on all of your credit cards by the credit limit on those cards. The lower your overall credit utilization ratio, the better it is for your credit score. Let’s take a look at an example using the three hypothetical credit cards:
Card 1 – $1,000 balance and a credit limit of $3,000
Card 2 – $2,000 balance and a credit limit of $4,500
Card 3 – $0 balance and a credit limit of $2,500
In this situation, your total balance outstanding is $3,000 and your total available credit is $10,000 for a credit utilization ratio of 30%.
How can I use this to help my credit score?
Knowing how your credit utilization ratio is calculated and how much influence it has can help you to keep your credit score as high as possible. For example, let’s say that you decided to cancel card #3 because you don’t use it very often and it has a zero balance on it.
On the surface that might seem like a responsible financial move, but now that you know about credit utilization rates, you know that doing this will raise your utilization rate to 40% by lowering the total amount of credit you have available.
The credit rating agencies generally agree that a credit utilization rate of around 30% or lower can lead to a higher overall credit score. This could mean the utilization rate on individual cards as well as on all of your cards cumulatively.
Even the data shows how people with lower credit card utilization ratios tend to have higher credit scores:
Ways to keep your credit utilization rate under control
Some tips for keeping your credit utilization rate low include the following suggestions:
- Don’t cancel a card simply because it has a zero balance. Keeping a credit card account open and using it occasionally can lower your utilization rate and improve your credit score.
- If a single card has a high utilization rate, focus on paying down that card first (assuming your interest rates are relatively equal). However, be sure to make at least the minimum payment on your other cards too.
- Ask your credit card issuer for an increase to your credit limit. This is a simple way to quickly lower your utilization rate – just don’t treat this as a reason to charge more to the card!
When it comes to calculating our FICO-based credit scores, the major credit reporting agencies follow some pretty clear guidelines. Keeping your credit utilization rate under 30% can lead to a higher credit score, even if all other factors remain the same.
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