When a credit report is being generated by a bureau, one of the parameters that they give significant weightage to is the credit utilization limit that is assigned to a credit card user. To define this is rather simple – it is the total credit card balances utilized against the total limit assigned (across all cards).
How does credit utilization affect the score?
When a card issuer assigns a credit limit when underwriting the card application, what they take into account is the person’s income, expenses etc. – much as they would in case of any other loan product such as a home or car loan. Whether you hold one card or even as many as five of them, the utilization limit is calculated basis your usage across all cards.
When a lender views this ratio, what they get is a fair insight as to what sort of borrower you must be. For instance, someone who is consistently close to maxing out or reaching the overall credit limit is likely to be a person who cannot handle debt well, and possibly relies on credit to make even ends meet. This means that if they were to extend further debt, it is likely that the borrower would not repay. And with a low credit score, your chances of loan approval are lower, even though there are loans for low credit score in the market.
On the flip side
Not having an utilization ratio at all does not help, either, because this means that you have no credit history that indicates your creditworthiness. Instead, stick to a lower utilization rate and you will see a marked difference in your credit score. As a general rule, individuals with low credit utilization have a higher credit score, but those with 0 percent utilization actually do have a score lower than those with a low score. It is suggested to keep the ratio between 1 to 30 percent, if you want it to have a positive impact on your score over the long run. Remember that once your score has dipped low, while it is not impossible to better it, to increase credit score takes some time.
How to manage credit utilization
Here are a few tips to manage credit utilization smartly, so that your credit score does not take a hit, and at the same time you can build your credit score so that your financial life does not take a hit.
Increased credit limit – Probably the fastest route to reduce your credit utilization limit would be to request for an enhanced limit across your existing cards. The math is simple – with a higher limit, the balances automatically come down. This would bring down the limit almost immediately, but then do keep in mind that you should not overspend again, else you will find the balances alarmingly high again.
Track your card usage – When you toggle between multiple cards, it sometimes becomes difficult to keep track of your spends. To avoid this, make sure that you monitor your card usage carefully, and take care not to exceed the limit. A prudent thing to do would be to time your spends across the billing cycle of the cards, and ensure that each individual card balance does not cross 30 percent.
Sign up for alerts – Do check with your credit card issuer whether they would be able to help you with setting up SMS and/ or email notifications that alert you when you have reached a certain balance limit on your card. For example, a common alert that card issuers provide is to inform the customer about the available credit balance. This should help you estimate just how much scope you have to further use the card.
Billing pattern – Let us say that for a particular month you know that you may have large spends that will tip your utilization limit over the 30 percent. Before the statement comes in then, consider paying off a part of the amount, which will immediately bring down your balance outstanding by that amount. Of course, do be judicious is flexing this option, as you want your balance to be down consistently, and ideally by keeping your spends low.
What you should do
To manage your credit utilization effectively, even if you are not too keen on making regular or large ticket spends on your credit card, do keep the card active by making small spends on the card. This helps build your credit history and helps a lender to see that you can manage your debt well.
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