Is Your Credit Utilization Too High? Here’s How to Improve It.

It’s that time of month when all of your bills are due. You’ve managed to pay your rent, utility bills, auto loan, and even squeeze in a credit card payment. Your bills have all been paid, and more importantly, paid on time. You’re in a good spot -- right?

Paying your bills on time is definitely key to keeping your personal finances in order. However, when was the last time you took a step back and looked at the big picture? Do you still have an outstanding balance on that credit card account? What about student loans? A mortgage? These personal loans may be dragging you down more than you think.

Debt and your credit score

Paying your debt on time is the most important part of your credit score, but nearly equally as important is the amount of debt you take on. This part of your credit score is called your credit utilization.

Your credit utilization is the amount of credit you’re using from your total credit limit and is made up of your revolving debt. For most people, this involves credit cards. This differs slightly from your debt-to-income ratio, which takes into account all of your debt. 

Your credit utilization determines your credit utilization ratio -- in other words, the percentage of your available credit that you have borrowed. 

What is your credit utilization ratio?

Your credit utilization is usually calculated as a ratio. To calculate your credit utilization ratio, divide the total amount of revolving debt you owe from your total available credit and multiply it by 100.

For example, if you have a credit limit of $1,000 and have made $400 worth of purchases this month, your credit utilization is 40%.

Your credit utilization ratio is used by lenders to gauge your creditworthiness. If your ratio is too high, it looks as if you depend too much on your credit. This can make lenders more hesitant to issue you a loan, because they may not think you’ll be able to pay them back.

What’s considered a good credit utilization ratio?

Typically, the golden rule in credit scoring is to keep your credit utilization rate as low as possible and no more than 30%.

Staying as far away from your credit limit is the key to improving and maintaining a good credit utilization ratio, which will help your credit score. The closer you are to the credit limit, the riskier you look to lenders.

If you have a $1,000 credit limit and you use up $950 of it, you’re communicating to your lender that you need more than the amount they’ve given you, as you’ve used up nearly everything that’s been extended to you. It makes it look as if it would be a stretch for you to pay the money back when you spend all the way up until the limit.

“Treat your credit card like an inconvenient debit card,” says Phil Schuman, executive director of financial wellness and education at Indiana University and executive director of the Higher Education Financial Wellness Alliance. “You wouldn’t spend money you didn’t have. Even if your credit limit is higher than what you have, only spend what’s in your bank account.”

People with nearly perfect FICO credit scores have an average credit utilization ratio of 10% on their credit cards, according to Experian.

How to improve your credit utilization ratio

If you are using a large percentage of your revolving credit, it may be dragging down your credit score. There are some ways borrowers can lower their credit utilization; however, you will want to weigh the pros and cons depending on your personal situation.  Here are three to get you started.

No. 1: Open a new credit card

If you’re in a good financial position, opening up a new credit card can help your credit utilization ratio. Opening up a new card can give you more available credit, lowering your overall credit utilization -- but only if you can handle this new increase. If you are planning to use the new credit card as a justification to spend more money, you won’t be doing yourself any favors, so keep an eye on your total balance. 

“Be responsible using one credit card, then get a second one,” Ramon DeGennaro, Ph.D., a professor in banking and finance at the University of Tennessee, Knoxville.  “You don’t want to wait until you have a low score and then have to get another one.”

With a new credit card, you can spread your debt out, which can help improve your ratio.

Instead of putting $500 on a single credit card with a $1,000 limit, if you open another card with a $1,000 limit, you can put $250 on each card. This will shift your ratio from 50% to 25%.

Having a second credit card can also serve as a backup if you misplace the other one.

No. 2: Pay your balance before it’s due

Your credit utilization changes as you make purchases and pay off your card. If you’re not carrying over a balance, your ratio may be pretty low near the beginning of the month, as you haven’t made a lot of purchases on your card yet.

Most credit card issuers report your balance to credit bureaus when your bill is due, but some card issuers may report it at different times in the billing cycle. If you pay your balance before your credit card company reports it or pay prematurely, it can positively impact your ratio.

Make it a habit to pay off your credit card balance every time it hits a credit utilization that is above the recommended amount. Setting up a  balance alert on your account can help you know when you're about to hit that number. When you pay down the balance in small amounts, you can maintain a lower credit utilization ratio.

No. 3: Ask for a  limit increase

If your income goes up or it’s been a long time since you’ve opened your credit card, it may be time to ask for a bigger line of credit.    

Credit card issuers will usually do a hard inquiry to determine if you’re a qualified candidate for a credit limit increase, which can knock off credit score points. They’ll factor in things like your spending patterns, payment history, and credit report

If you don’t think you’ll be able to control your spending with a higher credit line, this probably isn’t the best financial decision for you, as increasing your credit card debt will hurt your credit score.

“If raising your credit card limit will just give you a license to spend more, then it’s probably better than you don’t give yourself an opportunity to take on more debt,” Schuman says.

What can hurt your credit utilization ratio

A variety of factors and decisions can impact your credit utilization ratio, including the following:

No. 1: Using all of your available credit

One of the biggest misconceptions about your credit limit is that as long as you don’t spend above your credit limit, your credit score will be okay. While this sounds like it should make sense, you’ll actually need to stay significantly under your credit card’s limit to maintain a good credit score.

Even if you pay off your card weekly, every credit bureau and credit scoring system factors in the use of credit differently. Just because you used $600 of your available $1,000 credit limit and pay it off immediately, you aren’t automatically in the clear.

“In general, you should err on the side of caution,” Schuman says. “You don’t know exactly how they’re going to look at your use of credit.”

No. 2: Chasing rewards and credit card points

The more you spend, the more reward points you’ll earn, but if you’re inching closer and closer to your credit card limit for the sake of points, it can hurt your score. Receiving 1% cashback isn’t worth the reward if it’s going to ding your credit score. This can make borrowing more expensive in the future.  

“Don’t just use a credit card for the cashback,” Schuman says. “The companies know this is how you spend more money.” 

No. 3: Closing a credit card

Closing a card can shift your credit utilization ratio if your debt was spread out over a couple of credit cards. Closing a card decreases your available credit. If you’re trying to get your spending under control, this is probably a better decision for you in the long run and could be worth it.

No. 4: Overspending

Your credit utilization is tied directly to your credit card spending. It may seem too simple, but decreasing the purchases you put on your credit card can make an impactful difference to your ratio.

“Most people in financial trouble don’t have an income problem. They have a spending problem,” DeGennaro says.

The bottom line 

While credit utilization is an important factor to monitor, your payment history triumphs it. For this reason, opening up a new card or increasing your credit card limit should only be done if you’ll be able to pay on time.

If you miss a payment, call your credit card company immediately. Many credit card companies want to work with you.

“There’s no shame in groveling to fix a mistake you made with your credit card company,” DeGennaro says. “Do anything you can from having it hurt your credit score.”

Ramon P. DeGennaro is the Haslam College of Business professor in banking and finance at the University of Tennessee, Knoxville. His research involves financial markets and institutions, financial regulation, small-firm finance, and public policy. 

Phil Schuman serves as executive director of financial wellness and education for Indiana University and is the executive director of the Higher Education Financial Wellness Alliance. He is also the co-creator of MoneySmarts U, an interactive financial education platform that provides financial education to college students across the country.