What Is Credit Utilization and How Does It Affect Your Credit Score?

 Credit score

Understand your credit score Image Source: Flickr CC User Dorte

Rebuilding and protecting your credit score after bankruptcy is easier if you understand how your FICO score is calculated. Five factors make up your credit score calculation. One of those factors, “credit utilization,” is particularly important since it makes up 30% of your score. Today we’ll explain what it is and offer some tips on how to manage it.

What Is Credit Utilization?
In the simplest terms, credit utilization is the amount of debt you're using compared to your credit limit. It's calculated as a ratio. However, it's a little more complicated than that. Credit utilization is actually made up of six components:

  • Amount of debt owed to various lenders and creditors
  • Amount of debt owed on accounts individually
  • Number of accounts with a debt balance
  • Types of accounts with debt balances
  • Percentage of credit lines being used (i.e. credit cards)
  • Percentage of debt owed on loans (i.e. mortgage or auto)

This is also called the debt-to-available credit ratio or balance-to-limit ratio.

The 30% Utilization Myth
If you Google “credit utilization” looking for tips on how to improve your credit score, you might read about the 30% rule. Some websites will tell you that you’re okay as long as you don’t exceed 30% utilization of any line of credit, but that is a myth.
There is no 30% magic threshold. In fact, you can take a credit score hit at less than 30% utilization on some credit cards. The issue is that credit score calculations are incredibly complex, and different factors impact how your utilization score is calculated.

So What Utilization Is Best?
When it comes to credit cards, you might think that sticking with 0% utilization is safest. However, utilization slightly higher than 0% is healthier for your credit score. You should use your cards to encourage your card issuers to periodically increase your lines of credit.
The higher your lines of credit, the lower your utilization will be when you carry a balance. For instance, if you carry a balance of $50 per card over each month and have five cards each with a $500 limit, that’s a total of $250 of debt on a total of $2,500 of credit lines.
That gives you a credit utilization on your credit cards of 10%. But if your creditors bump your limits to $1000, your utilization with the same balances drops to 5%. Realistically, carrying a very low balance can be helpful – even if it’s just a few bucks.

How Do You Improve Your Score Without Racking up Debt?
Using your credit cards is the best way to get credit line increases periodically, but you don’t want to risk getting in over your head with debt. Consider using your cards to pay utilities, fuel your car, and buy groceries, since this is money you normally spend anyway.
Then, on payday, instead of paying those bills, pay down the credit cards you used to charge the necessities. That keeps your cards in use which makes your card issuers happy. But by paying in full each payday, you'll avoid paying interest.
Credit utilization is a game of balancing. You need to use your cards to keep the accounts open – card issuers will shut down cards that don’t get used. Spreading out necessities on various cards so that each card gets used at least once every few months will keep you in good standing.

How Not to Use Your Cards
Debt spending is dangerous and can lead to money problems. If you charge things on credit cards but can’t afford to pay them off in full each month, you are debt spending. In emergencies, you may need to use your plastic and carry a balance (to repair a car or dishwasher, for instance), but this shouldn't be your typical manner of spending.
Think of your credit cards as a tool to improve your credit, not as a source of funds for spending beyond what you can afford based on your wage and budget. Carrying balances is not a good idea and can be a slippery slope to out-of-control debt.
To find out more about improving and rebuilding your credit score after bankruptcy.