Understanding Credit Utilization

With the recession, a lot of personal finance experts have started dispensing credit advice. They advise that you never cancel cards because it’ll hurt your score. Do you know why?

While all of their advice is correct, it’s important to understand why it’s correct. It’s better to know why you’re doing something than to just do it blindly. Today I’ll discuss the second most important and one of the most misunderstood aspects of your credit score – credit utilization.

Credit score savvy consumers probably know that your FICO credit score is based primarily on five factors:

  • Payment history (35%)
  • Amounts owed (30%)
  • Length of credit history (15%)
  • New credit (10%), and,
  • Types of credit used (10%).

Credit utilization is one part of “Amounts owed” factor but it’s an important part, it counts for 20% of your score. Credit utilization is a simple equation and measures how much of your available revolving credit is being used each month. Divide the sum of your account balances by the sum of your account credit limits.

An important and often misunderstood aspect of credit utilization is that it doesn’t matter if you carry a balance or pay off your entire balance every month, it’s just the ratio of credit used to credit available. It also doesn’t matter how large your balances or limits are on their own. Only the percentage used is important for this metric.

Why does closing a credit card account hurt my score? It hurts your score because your credit utilization will go up, which is bad. If you have two cards with $500 limits and you charge $250 to one and $0 to another, your utilization is 25%. If you keep your spending the same but cancel the second card, your utilization jumps to 50%. To a lender, you’re a risk because you use 50% of your available credit each month.

What’s a good utilization? A variety of experts say under 10% is best but 30% is acceptable (Motley Fool). In the end, there’s no magic number, the lower it is the better.

So I should apply for a million cards to increase my total limit right? Wrong, because that will hurt you in the “New credit” factor more than the lowered utilization will help you.

So, keep your utilization low, your credit report accurate, and we’ll be out of this recession in no time!

Jim writes about personal finance at Bargaineering.com.

(Photo: jadedhalo)