If you’re paying off your credit cards to improve your credit score, read this post first.
By the end of this post, you’ll know not to automatically close all your paid-off accounts — even when the total balance hits $0. Closing these accounts could hurt your credit utilization ratio.
About 30 percent of your credit score comes from your credit utilization ratio — a number that tells creditors how much of your available credit you’re using.
On a credit card with a $10,000 limit, for example, a $9,000 balance means you have a 90% credit utilization ratio for that card. Such a high utilization ratio would hurt your credit score.
Table of Contents:
What Is Your Credit Utilization Ratio?
I’m sure you’ve heard the saying “the rich just get richer.” If you’re like me, you probably know some people who prove this old adage is true.
It’s definitely true for your credit life. People who already have a lot more credit than they’re using — people with low credit utilization rates — have a better chance of getting new credit.
That’s not all: They also have a better chance of getting lower interest rates on new credit cards, and they have access to nice perks like cashback offers and low annual fees. In other words, they get more financial tools available to maintain a good credit score.
On the other hand, if your credit card debt has reached, or even eclipsed, your maximum available credit, you’ll have more trouble opening new accounts or getting competitive interest rates and higher spending limits.
Why? Because your credit utilization rate is telling creditors you’re not all that concerned about keeping your debt under control.
From a creditor’s point of view, you’re more likely to run up a large balance and then struggle to make payments to keep your credit card account in good standing. Statistics show you’re more likely to default on a revolving credit account.
How Credit Utilization Affects Your Credit Score
Most credit scoring models weigh your credit utilization ratio as about 30 percent of your credit score. Here’s the breakdown:
- 35% based on Payment History
- 30% based on Credit Utilization Rate
- 15% based on the Age of Your Accounts
- 10% based on your Credit Mix
- 10% based on Hard Credit Inquiries
As you can see, only your payment history has a bigger influence on your credit score than your credit utilization rate.
And, like many things in your personal finance life, these different components of your credit history have a tendency to interact with each other, exacerbating the effects of a single weak spot.
Take your payment history, for example. If you have a number of late payments on your record you may have a couple hundred dollars in late fees added to your accounts.
These late fees will eat into your available credit which harms your credit utilization ratio as well as your payment history.
Late payments may also prompt your credit card issuer to hike your interest rates which increases total balances more quickly. This also cuts into your available credit.
So late payments alone can impact 65% of your credit score (35% payment history + 30% credit utilization rate).
What Is A Good Credit Utilization Ratio?
I recommend keeping your credit card utilization rate at or below 25%. I know this is a difficult goal to achieve, especially if you’re barely keeping up with swelling credit card balances as it is.
The good news: You can work toward this goal from two different angles:
- By paying down but not closing existing credit card accounts.
- By opening but not using new credit lines.
Either one — or both — of these strategies will help you raise the roof on your credit limit which should bump up your standing with the credit bureaus and, by extension, increase your FICO score.
How To Calculate Credit Utilization
Before I share more strategies about reducing your credit utilization ratio, let’s make sure you understand how to find your ratio.
You won’t find your ratio on your credit score. You’ll have to calculate your ratio by following these three steps:
- Adding together all the credit limits of your revolving accounts. For many people, this means credit card accounts, though it could also include other lines of credit. When you add together all your maximum credit limits, you’ll know your total available credit.
- Adding together all the account balances for these revolving accounts. This number will show your credit utilization.
- Dividing your credit utilization by your total available credit. The answer will be your credit utilization ratio.
Credit Card Utilization Ratio Example
Here’s an example. Let’s say you have four credit cards and one overdraft protection line of credit connected to your checking account:
- Chase Bank Visa Credit Card:
- Credit Limit: $5,000 / Account Balance: $4,800
- American Express Credit Card:
- Credit Limit: $10,000 / Account Balance: $2,200
- Capital One Credit Card:
- Credit Limit: $7,500 / Account Balance: $7,450
- Visa Small Business Credit Card:
- Credit Limit: $5,000 / Account Balance: $1,050
- Wells Fargo Checking Overdraft Line of Credit:
- Credit Limit: $1,000 / Account Balance: $0
Now let’s add together the credit limits and the account balances to get:
Total Credit Limit: $28,500 / Total Account Balances: $15,500.
Dividing $15,500 by $28,500 gives us a credit utilization ratio of: 54%.
Individual Card Ratios Matter, Too
So far we’ve focused on your overall credit utilization but creditors also consider each individual account’s utilization.
In our example above, the Capital One credit card utilizes almost 100% of its available credit. So does the Chase Bank Visa. Even though the example’s overall credit usage rate is 54%, these high balance individual cards could hurt the account holder even more.
Even if your overall credit utilization were under 25%, having one or two accounts with high balances could still be hurting your credit score, though not as much as a high overall credit utilization ratio.
Installment loans like mortgages or auto loans won’t affect your credit utilization percentage since they don’t have revolving balances. However, your ability to get new installment loans, including personal loans, is influenced, in part, by your credit utilization rate.
It’s About Ratio, Not Actual Numbers
I’m often asked whether a credit card limit’s dollar amount matters to your credit use rate. For example, a card with a $200 spending limit that uses 90% of its available credit means you owe only $180.
Shouldn’t this lower dollar amount — $180, which many people could pay off in a month — hurt you less than an $1,800 balance on a $2,000 spending limit?
No, not from the perspective of your credit utilization ratio. No matter how low your credit limit, this value measures how much of your credit you’re using. In both cases, you’d be using 90%.
When you are repairing or building your credit, getting a credit card will help, even if the credit limit is low. But make sure to pay off the account within each billing cycle to keep your rate low.
Then, as you begin to build credit, you can request a higher credit limit which will help lower your credit utilization percentage even more.
Remember: keep your utilization as low as possible –preferably at or around 25%. The right credit balance to limit ratio is key to optimizing your credit score.
Ways to Lower Your Credit Utilization Rate
We’ve already covered the basics of lowering your credit utilization percentage. In a nutshell, you should pay off your balances but keep accounts open.
You could also try to open a couple new revolving accounts that you don’t plan to use, although this may not be an option if you already have average or poor credit.
I also recommend some more nuanced strategies to help fine-tune this ratio:
First, Get Your Free Credit Score
Visit annualcreditreport.com to request your free copy from each credit bureau. Study the section on your credit accounts to make sure you’re counting all of your revolving credit balances.
Other Strategies to Consider
When you have a good handle on your open credit accounts, consider some of these strategies to improve your ratio or to maintain a good credit ratio:
- Ask for a credit limit increase: Sometimes a higher credit limit is just a phone call away, especially if your credit’s still in pretty good shape. Asking your credit card companies for a credit limit increase can deliver instant results. Just be sure you don’t use the new credit you have available.
- Open a balance transfer account: If you can qualify for a low-interest balance transfer card you could consolidate several accounts into one and pay down the new card’s balance more quickly. Don’t close the accounts after you transfer their balances, but don’t use these cards anymore either.
- Use a credit monitoring service: Services like Credit Sesame and Credit Karma won’t show you an official credit report but they can help you track your credit usage. These services also recommend new credit cards that can help you improve your credit utilization ratio.
- Set up balance alerts: The best credit cards will send you balance alerts to your smartphone or email inbox when your card approaches its credit limit. These alerts can help you remember to address your credit utilization rate.
- Pay on your balances more than once a month: By paying twice or three times a month, you prevent your balance from increasing and lowering your credit utilization percentage. (This is much easier if you use your credit card issuer’s app to make payments.) This strategy keeps your credit card company from reporting debt that’s temporarily high, artificially deflating your available credit.
Don’t Over-Analyze Your Credit Utilization Rate
Credit reporting and credit score calculation formulas include a lot of nuances. Any hard-and-fast rule — such as keep your credit utilization percentage below 25% — comes with exceptions.
For example, if everything else in your credit life is spectacular, surpassing the 25% mark for credit use won’t automatically sink your credit score. Your pristine payment history and your perfect blend of types of credit should help you keep a healthy score.
Instead, you should consider these kinds of rules general guidelines to follow, remembering that improving other areas of your credit life will also help your credit utilization ratio.
Other Ways to Improve Your Credit Score
To improve your credit score, follow these basic rules:
- Make All Payments On-Time: This is the biggest component of your FICO score. Set up automatic payments, if necessary, to make sure you pay accounts on time.
- Keep Paid-off Accounts Open: As you know from this post, your available credit helps your score. As you pay off debt, consider keeping revolving accounts open even when they’re paid off.
- Limit Hard Inquiries: More than a few hard credit inquiries within a year can lower your FICO score some. Soft inquiries — such as checking your credit score or getting a pre-approval for a mortgage — will not harm your FICO score.
- Keep a Variety of Accounts Open: Keeping a mix of accounts — a mortgage, a personal loan, a couple car loans, and a few credit card accounts — will help your score.
- Be Patient: The age of your existing accounts helps bolster your FICO score. If you’re a young adult just starting to build credit, be patient for a few years while your accounts age.
- Monitor Your Score: Get your free credit score every year and consider using credit monitoring services, even if they just share your Vantagescore which can clue you in to big changes in your actual FICO score.
- Try to Save an Emergency Fund: Keeping an emergency fund that could pay your monthly bills for at least three months will help decrease your reliance on credit. If you lost your job — as many people have during the pandemic — you won’t have to immediately turn to credit cards, zapping all your available credit.
When you’re trying to fix credit score problems, you can achieve results by addressing your credit utilization ratio.