Credit scoring is a mystery to many people, and for good reason. It’s not easy to understand the grading process or which factors matter most.
While every lender has its own method for deciding which customers are worthy of financial trust, more than 90% of top U.S. businesses rely on the FICO score when reviewing credit and loan applications, according to the company. Of course, you have more than one FICO score, so you might be feeling confused all over again, but here’s the good news: When it comes to credit health, it’s best to narrow your focus to five main factors:
- Credit length
- Payment history
- Account diversity
- Credit utilization
Why Is Credit Utilization So Important?
Every factor of credit scoring is crucial, but credit utilization is responsible for 30% of your overall score, second only to your payment history’s weight of 35%. Credit utilization measures your revolving balances against your total credit limit. Lenders and credit card issuers rely on credit utilization to predict risk and future behavior. In general, the higher your utilization ratio, the greater your risk of defaulting on your balances. Risky behavior isn’t rewarded in the world of credit scoring, and you may see a decrease in your scores as your utilization ratio goes up.
To understand credit utilization, you first need to understand your line-item and aggregate calculations.
Line-item utilization measures your individual credit card balances against your individual limits. For example, suppose you have three credit cards, each with a $10,000 limit. Based on your current balances, your line-item utilizations break down like this:
Card A: Balance of $4,500 / Credit limit of $10,000 = 0.45 × 100 = 45% utilization
Card B: Balance of $2,000 / Credit limit of $10,000 = 0.20 × 100 = 20% utilization
Card C: Balance of $3,300 / Credit limit of $10,000 = 0.33 × 100 = 33% utilization
The average of your credit card utilizations is called aggregate utilization. Calculate yours by combining your current balances and dividing them by your total credit limit. In the example above, your total balance is $9,800 and your total limit is $30,000; therefore, your aggregate credit utilization is $9,800 / $30,000 = 0.32 × 100 = 32.6%
Which One Matters?
Line-item and aggregate utilization are both important factors in overall credit health, and FICO recommends keeping yours as low as possible.
How to Benefit from Credit Utilization
Credit utilization has an undeniable affect on your credit score, and there are ways to harness its influence in your favor. (Not sure where your credit stands? You can view two of your scores for free on Credit.com.)
Keep Your Balances Low
If you struggle to curb spending or rely on credit cards to make ends meet, overhauling your budget is the first step. A few monthly changes could help you avoid overwhelming debt and related credit damage.
Check Your Credit Reports for Accuracy
Your credit reports tell the larger story of your financial history and responsibility, and accuracy is key. For example, suppose Card A’s $10,000 credit limit is mistakenly listed as $6,500 on your credit reports. While it may seem like a small issue, an incorrect credit limit can alter your utilization ratio and damage your credit score in the process. In this case, your line-item utilization would increase from 45% to 69.2%, and your aggregate utilization would increase from 32.6% to 37%. You can’t afford to ignore the details. Order free copies of your credit reports to ensure that they accurately reflect your credit card balances and limits.
Request a Limit Increase
If you’re working on debt reduction but need a quick fix, consider asking your lenders for limit increases on each of your cards. For example, increasing Card B’s limit to $15,000 would lower your line-item utilization from 20% to 13.3%, and your aggregate ratio from 32.6% to 28%. Requesting a limit increase could place a hard inquiry on your credit file, costing your score a few points, but the benefits of lower credit utilization are usually worth the temporary ding.
Change Your Bills’ Due Dates
It’s difficult to benefit from credit utilization if you are constantly battling the clock. If your credit card issuers report customer balances to the credit bureaus before you pay your bill, it may seem like your utilization ratio is constantly high. The fix? Contact your issuers and ask them when they typically report to the credit bureaus, and then move your bill’s due date to the week before. This strategy allows you to take full advantage of low credit utilization by giving you time to pay your balances before the reporting date.