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Debt is a double-edged sword. Not only does carrying a lot of it put a strain on your monthly cash flow, but it also makes it more expensive for you to take out additional debt. One of the most significant ways this occurs is through your credit card utilization ratios. Sound complicated? It’s not, really, and understanding it can have a huge impact in your debt management.
What is a Utilization Ratio?
Your utilization ratio is the percent of your credit limit that you are using at any given point in time. You have a ratio for each separate credit card you use, plus an aggregate ratio from combining all of your credit card balances and limits.
If you only know one thing about utilization ratios, know that the higher the ratio, the worse off you are financially. In particular, the higher your ratio, the lower your credit score will be. This is true of your ratio on each credit card and your ratio overall.
Let’s look at some hard numbers to make this a little bit more concrete. Let’s say you have three credit cards: a Visa, a MasterCard, and a Discover. Your Visa has a credit limit of $6,500 and a balance of $2,516 on your last billing statement. Your MasterCard’s limit is $4,000 and the balance is $3,312. Your Discover has a limit of $3,000 and a balance of $239.
The utilization ratio on your Visa is $2,516/$6,500, which is 39 percent. Using the same formula, your ratios on the MasterCard and Discover, respectively, are 83 percent and 8 percent.
To calculate the overall utilization, add together all of the balances and divide the result by the sum of your credit limits. In this case, your total balances are $6,067 and your total credit limit is $13,500. This gives you an overall utilization of 45 percent.
Impact of Opening and Closing Credit Cards
One of the interesting factors to consider is how opening or closing a credit card or changing your credit limits affects your overall utilization.
If you open a new credit card with a high limit and no balance, you get to add the limit to your overall total without adding anything to your overall balances. This should lower your overall utilization. Likewise, increasing your limit on an existing card without increasing your balance also helps your overall total.
On the other hand, closing a credit card with no balance can really hurt your utilization. In the above example, say you pay off the last $239 on your Discover card and close it. Now your total balances on your other two cards are $5,828 and your total credit limit has dropped to $10,500. That makes your utilization 56 percent, rather than the 45 percent you had before you closed the Discover card.
Lowering Your Utilization
Experts agree that utilization ratios of 10 percent or less won’t hurt you. And actually, it’s generally better to have some utilization than none, because it shows that you use and repay credit, rather than not using it at all. When your utilization on a single card or overall is above 10 percent, it starts hurting your credit score, with more damage coming with more utilization.
What this means for you is that if you’re planning to apply for any type of credit in the future, you want your utilization to be below 10 percent. This helps you qualify for the best interest rate possible.
If your utilization is above 10 percent, it’s time to work on paying down your credit card balances. A maxed out card looks really bad, so start by getting your utilization down to 90 percent or less on each card. Then get them each down to 50 percent. If you still have time before applying for your new loan, keep chipping away at the debt.
By lowering your utilization, you can qualify for lower interest rates on big purchases, like cars or houses. This can save you thousands of dollars in the long run!