This One Ratio Is the Key to a Good Credit Score

By Tara Struyk. Last updated 1 October 2014. 3 comments

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A credit score is a bit like the Da Vinci Code; it's a serpentine web of myth and mystery that's hard to crack. But there is a Holy Grail of sorts here too. Of all the different factors that feed into your credit score, many experts believe that there is one factor that stands above the rest in keeping your score high. The fact that this one ratio is so important is a little counterintuitive, so simply understanding its importance can unlock the higher credit score you've been looking for. (See also: How to Rebuild Your Credit in 8 Simple Steps)

So what is it? It's called the credit utilization ratio.

A Complicated Calculation

So what exactly is the credit utilization ratio? It's simply your total credit card balances divided by your total credit card limits. So, if you have, say, $15,000 of available credit on your credit card(s), and have an outstanding balance of $5,000, your credit utilization ratio is about 33%.

Now, that isn't so complicated and mysterious, is it? But where things start getting a little weird is when you come to understand exactly how this ratio functions in terms of your credit score. As a financially literate person who handles debt with caution (you're reading Wise Bread, after all), you might assume that having no more available credit than is strictly necessary is a good thing. After all, why have more available credit to tempt you away from sticking to your budget and staying out of debt?

Well, because it's important to maintaining your credit score, that's why.

Credit utilization accounts for about 30% of your credit score. And while on a strictly practical basis having less credit available to you is probably a good idea, experts typically recommend that you never allow your credit utilization ratio to exceed 30%. What that means is that if you have only one credit card with a relatively low $5,000 limit, you should never allow the balance to exceed $1,500. Even if you're a person who conscientiously pays off that card each and every month, that can get tricky. Use your card to get a great deal on a vacation online and you could blow your credit utilization ratio.

What it all means is that in order to have the best possible credit score, you need more available credit that you never use.

The Plot Thickens…

So let's dig a little deeper into how to get your credit utilization rate at an optimal level for your credit score.

Now, I mentioned that experts typically recommend that it not exceed 30%. However, research conducted by Credit Karma looked at 70,000 credit scores and their corresponding credit utilization rates and found that the lower your credit utilization rate, the higher your credit score — except if you have 0% utilization. In fact, those with the highest credit scores had a utilization rate of 1% to 10%.

It is also important to note that in the FICO credit scoring model (the most common credit scoring model used in the U.S.), credit utilization is scored in two separate ways. First, the credit utilization for each of your credit cards is calculated separately. Then, the total of all your credit card balances is compared to your overall credit limit. What that means is that not only is more available credit important to achieving a higher credit score, but that available credit should be spread out over more than one credit card.

Ideally, you should keep both your balance on each card and your overall balance across all cards as low as possible.

How to Beat the System

OK, so now that you've unlocked how the credit utilization ratio affects your credit score, it's time to look at exactly what you can do to keep your ratio at the most optimal level possible. Here are few key moves to make — without becoming a debt junkie.

Spend Less

One very simple way to improve your credit utilization ratio is to simply spend less on your credit cards. Work on converting to a cash budget and save up for big purchases in advance. It's as simple as that.

Expand Your Available Credit

When it comes to credit, less is definitely more, but it's better to use less than to have less available. So, if you're a person who regularly spends a lot on your credit card — whether for convenience or to earn points — it's best to make more credit available to keep your credit utilization ratio in the optimal zone.

But no matter how much credit you use, just be sure to pay off your balance on time every month — the age of your debts and your payment history have a big impact your credit score, too. If you don't trust yourself, open a credit card, then cut it up. The credit's available, but you won't be using it.

Be Careful About Closing Credit Cards

Closing credit cards can be a good debt reduction strategy, but not if it pushes your credit utilization ratio up. If you want to reduce the amount of available credit you have, cut your spending and average monthly balance first.

Watch the Rest of Your Score, Too

Of course, credit utilization isn't the only factor in your credit score. Your payment history, age of credit, mix of credit, and credit inquiries all play a role. Improving your credit utilization ratio is a simple way to boost your credit score, but it isn't the only way. And, if you have bad credit as a result of past financial decisions, it shouldn't be the only way.

The Big Reveal

If you're feeling confused about why you would be rewarded for having more available credit, it's important to remember exactly who's in charge of the entire notion of a credit score: lenders.

So, while having a good credit score can have a lot of financial benefits for you, the scoring itself isn't designed for your benefit; it's designed to help credit card companies and other lenders protect their interests. What that means for borrowers is that getting the best credit score isn't necessarily about making what appears to be the most logical financial choices; it's about playing the game. Just be sure you play it to win.

What do you do to keep the best possible credit score? Please share in comments!

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Guest's picture
Guest

Another tip - For most cards your balance is reported on the statement date so if you pay your balance before the statement date it won't be reported and you'll have a much lower credit utilization.

Tara Struyk's picture

I hadn't heard of this. Great tip!

Guest's picture

For best results, have an overall utilization of 1-10% and carry a balance on a maximum of one to two cards. The sweet spot (between 1-10%) seems to vary based on your individual credit profile.

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Guest

How do Home Equity Loans factor into al of this?