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When it comes to boosting your credit score, you’ll hear about your credit utilization ratio. I take a look at what this is, and why it is so important.
When you apply for a loan or a credit card, a lender is going to look at your credit score. This is an indication of how much of a risk you are. In some cases, you may be declined due to your low credit score. In other cases, you could end up with a higher interest rate than someone who has an excellent credit score.
Part of your credit score is affected by your credit utilization ratio. It is a strong indicator of how well you handle your money and your debt. Not sure what it exactly means? That’s okay, I’ve got you covered.
What is your credit utilization ratio?
The credit utilization ratio is usually given as a percentage. It indicates the percentage of the credit you use based on the amount you have available.
Let’s say you have $10,000 available across loans and credit cards and you’ve used up $5,000 of that. Your utilization ratio is 50%. If you have used just $1,000 of the available money, you’ve used 10% of it.
The lower the percentage, the better it is for you. It’s important to stick to 30% or below for the best credit score chances.
How is the ratio calculated?
You’ll be able to work out your percentage per credit card and loan. In a lot of cases, the entire amount you have available is collected together and the percentage is based on the total amount you’ve used.
Let’s say you have one credit card with just $1000 available to use but you have a $9,000 loan also available (I’m working with easy numbers, okay!). That means you have $10,000 in total available. If your loan is maxed out but you’ve touched nothing on your credit card, your ratio is going to be 90%. If you have just $1000 left on the loan and your credit card is maxed out, you’re at 20%.
Of course, lenders will check on the individual balances as well. This is important to see how well you manage your money across the board. You want to try to keep each individual loan and credit card to below 30%.
Loans are looked at a little differently, though. The loan involves a regular payment plan, while a credit card is a revolving debt. They’re considered by lenders for your applications in different ways as they show something slightly different—your ability to pay down long-term loans and stick to an agreement vs. your everyday spending.
Why is your utilization so important?
So, why should you keep your credit utilization ratio down? Why is it so important for your score? It’s all linked to showing lenders what you are like with your money.
The lower your ratio, the better you look with spending. It shows that you don’t spend past your means and that you pay back everything on time. It shows that you are sensible, and you’re not at risk of defaulting on payments.
If a lender thinks you may end up defaulting or potentially claiming bankruptcy, they aren’t going to lend money to you. The ratio is a way to see the risk. It doesn’t give the full picture, but it’s a good one to see how careful you are with spending.
MORE: 3 tips to boost your credit card to boost your credit score
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