“Debt utilization” sounds, at first blush, like a complicated element of corporate finance, and while the term is certainly applicable to the world of big business, that’s not the context in which it is used here. At the consumer level, debt utilization represents an important component of one’s overall credit profile, and refers to the degree to which available revolving credit is actually used. While debt utilization seems like a subordinate issue that many believe is nowhere near as significant to a credit profile as late payments and collection items, the truth is that debt utilization impacts between one-quarter and one-third of a typical consumer’s credit score. Accordingly, it’s appropriate that we take a closer look at the subject, so that you are able to more beneficially manage your own credit score as you navigate through increasingly-choppy financial waters.
How many times have you heard the old saw that “banks only loan to people who don’t need any money?” The saying refers to the basic truth that banks are more eager and willing to loan money to people who have a long history of financial stability (and thus, presumably, don’t really “need” money), and are much less inclined to lend to those who have checkered financial histories (the very histories that tend to suggest they are much more in need of the cash). Well, the same, general idea applies to the matter of one’s debt utilization ratio, and how that’s viewed by the process that determines credit scores – the less you use your available credit, the higher the score that evaluates your use of that credit. So, am I saying that one of the best ways to help ensure a high credit score is to use your available revolving credit balance as low as possible? Basically, yes.
Before going any further, let’s talk more about revolving credit, and just what it is. There are, broadly, two types of credit lines that a consumer may have: revolving, and installment. Installment credit is that which an individual uses for a fixed period of time to purchase a specific, big-ticket (usually) consumer good, like an automobile. As noted, the term of the loan is fixed, like 48 months, as is the monthly repayment amount. Once the repayment is made in full, the account is closed. With a revolving credit line, the consumer borrows against an established “open” line of credit, such as that represented by a credit card, and may borrow up to the limit set by the credit grantor. As the balance is repaid, the available space on the credit line may be reused by the account holder for new, ongoing purchases. Another feature of revolving credit is that the size of the monthly payments is not fixed; although a minimum amount, recalculated each month, must be paid basically every 30 days, the account holder may pay just that sum, or any amount greater.
Debt utilization pertains to revolving credit, because the inherent nature of revolving credit means the account holder has discretion over how much of the available credit in a revolving line he actually uses. It is said that those with the highest credit scores use, on average, only about 8 percent of their available, revolving credit. Don’t miss the significance of this – even if you have never missed a payment, and have made all of your payments on time (behaviors which are also very impactful when it comes to credit score), your credit standing will nevertheless be diminished as you carry higher balances. Potential future credit grantors view high utilization ratios as being indicative of higher-risk debtors.
So, what’s your current debt utilization ratio? Total up the credit limits associated with each one of your open, revolving credit lines, and then total up the current balances. Divide the balances by the limits, and you’ll have your utilization number. For example, let’s say your revolving credit is represented by two credit cards, each with limits of $5,000 – this means your total available credit is $10,000. Now, let’s say the current balances of each total $7,000. Divide $7,000 by $10,000, and you will see that your current utilization ratio is 70 percent. That’s not good. Even if you’ve yet to make any late payments, potential grantors of credit will interpret a 70 percent ratio as a cue that you’re heading into dangerous territory, where your credit balances may soon become unmanageable. The best way to handle revolving lines of credit for the purpose of strengthening your credit score is to make small purchases that you can easily pay in full each month – that way, you create a regular payment history of timely payments, and also keep your utilization levels, at any given time, at just a few percent.
While it may not seem fair to some that a credit score can be adversely affected by higher utilization levels while one’s payment record remains pristine, that is how the system works. In truth, it’s not difficult to see, if you think it through, why high utilization levels are viewed as potential minefields by “the system.” The takeaway for you is to know it matters as much as it does, and to keep your utilization ratio as low as possible.
The information contained here is for general information purposes only. Bob Yetman disclaims responsibility for any liability or loss incurred as a consequence of the use or application, either directly or indirectly, of any information presented herein. Nothing contained in this article should be construed as a solicitation or recommendation to engage in any financial transaction. You should seek the advice of a qualified professional before making any changes to your personal financial profile.