Credit cards can make shopping a breeze. You can go from store to store without carrying cash or accumulating jingling coins. It might seem like these pieces of plastic give you an endless amount of money to spend, but it’s important to remember that credit cards come with credit limits. And how close you come to reaching that limit has an effect on your credit score.
The Meaning Behind Your Credit Utilization Ratio
Whether the credit line for your credit card is $2,000 or $10,000, that number wasn’t made up out of thin air. When you applied for the card, your lender likely looked at your financial background and assigned you a credit limit based on your income, your credit score, bankruptcy risk and/or your debt-to-income ratio (how much you’re putting toward paying off debt each month relative to your income).
However it was decided, your credit limit is an important number to know. If you “max out” your credit card this means you spend up to the limit. When this happens, you will likely see the impact on your credit score.
Your credit utilization ratio is the percentage of your available credit that you are using (your credit card debt divided by your credit limit). You might be under the impression that you’re free to spend up to the limit without experiencing any adverse effects. We hear you saying, “My credit card issuer said I can spend up to $6,000. It’s OK if I max out my card this month, making student loan payments or taking care of the mortgage loan on my house…right?” Nope.
Your credit utilization ratio (also known as your debt-to-credit ratio or your balance-to-limit ratio) is one of the factors used to compute your credit score. A higher ratio means a lower credit score.
How Your Debt-to-Credit Ratio Affects Your Credit Score
Your FICO® credit score is made up of five main components and each one carries a specific weight within the total score.
How you’ve dealt with debt and made payments in the past accounts for 35% of your score. The number and amount of new credit accounts you’ve opened as well as the different types of debt you have (credit cards, student loans, auto loans, etc.) combine to make up 10% of your score. The length of your credit history accounts for 15% of your credit score.
Finally, your debt-to-credit ratio and how much debt you carry together account for 30% of your FICO® score. All of this means that you might want to steer clear of your credit limit. It’s best to have as low a credit utilization ratio as possible. In short, a high debt-to-credit ratio can mess up (aka drive down) your credit score.
Note that the FICO® scoring model calculates two different credit use ratios. One is based on your debt-to-credit ratio for each credit card in your wallet. The other adds all of these numbers together to show you how much you’ve spent in total relative to all of your credit lines.
Credit cards in particular matter to the three credit reporting bureaus. Other forms of debt that you might hold don’t have the same impact on your credit score. Since credit cards allow you to carry a revolving balance that you can avoid paying off each month, credit cards carry more weight in the “amounts owed” section of your credit score than do debts from other loans.
Tip: Pay Off Existing Credit Card Debt with These Balance Transfer Credit Cards
How to Calculate Your Debt-to-Credit Ratio
The formula for calculating your credit utilization ratio is pretty straightforward. To figure it out for an individual card, divide your credit card balance by your available credit line. If you’ve only got one credit card and you’ve spent $400 out of a possible $2,000 this month, your debt-to-credit ratio is 20%.
But say you have three credit cards with credit lines of $1,000, $3,500 and $5,000. You can find your overall credit utilization by first adding those numbers. Then, divide your total balance across all three cards by the sum of your credit limits. If you’ve spent $200 on each, your debt-to-credit ratio would be about 6% ($600 divided by $9,500).
What’s the ideal debt-to-credit ratio for credit cards? FICO® suggests that a good debt-to-credit ratio percentage is below 30%. And that goes for your ratio on any one of your cards separately as well as for your overall ratio.
Just because you can spend a certain amount with your credit card doesn’t mean that you should. In fact, it’s a good idea to stay well below a 30% debt-to-credit ratio so your credit score doesn’t take a hit that’ll keep you from buying a house or refinancing an existing one. The lower your credit utilization ratio, the better.
In addition to keeping your spending in check, you can also lower your credit utilization ratio by increasing your credit limit. If you haven’t asked for a credit line increase in six months or more and your income hasn’t decreased, your credit card company will likely agree to raise your credit limit. But if increasing your credit limit will just tempt you to spend more, it’s important to be wary of that strategy.
Update: Still have financial questions? We can help. So many people reached out to us looking financial planning help, we started our own matching service to help you find a financial advisor. The SmartAdvisor matching tool can help you find a person to work with to meet your needs. First you’ll answer a series of questions about your situation and your goals. Then the program will narrow down your options to three fiduciaries who suit your needs. You can then read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while the program does much of the hard work for you.
Photo credit: ©iStock.com/pidjoe