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Credit utilization ratio – The credit score factor you may be overlooking

If you want the best mortgage rates, lowest interest rates on lines of credit, and access to the best credit cards, you’ll want a good credit score. Let me rephrase that, you’ll need a great credit score.

But what’s considered a great credit score? 

If your credit score is 650 or higher, it’s generally considered good. If it’s 750 or higher, it’s considered great. You can check your own credit score online for free with no consequences, and if you discover your credit score is a few points below that threshold, don’t panic.

There are steps you can take to improve your credit score like always making sure at least your minimum payments are made on time, keeping your oldest credit account open, and not applying for too many different credit cards at once.

You’ll also want to make sure that your credit utilization is within the recommended maximums. Credit utilization is one of the credit score variables that is often overlooked by Canadians, to our detriment. We’re going to take a closer look at credit utilization below because it’s one of the easiest ways to boost your credit score.

What is credit utilization

Your credit utilization is the ratio of your current credit balances relative to your overall limit. For example, if you have a credit card with a $10,000 limit, and you owe a balance of $3,000, your credit utilization is 30%.

In short, credit utilization measures your debt load relative to your total available credit.

It’s recommended that you keep your credit utilization under 30% on all of your financial products. That means if you have one credit card with a limit of $5,000 and another with a $15,000 limit, you should try to avoid regularly carrying a cumulative balance of over $6,000.

Why does credit utilization matter

Credit utilization is one of the single most important factors that goes into calculating your credit rating – second only to payment history – and accounts for a whopping 30% of your total credit score calculation.

The major credit reporting agencies prefer you only use up a third of your total available credit limit because, to them, regularly building up a balance over that is a red flag that you may be over-leveraged, over-reliant on credit, in more debt than you can comfortably pay off, and signals that you may be a higher risk borrower. 

The longer and more closely you hover near to your credit limit, the higher your credit utilization and the bigger the potential hit to your credit score.

How to improve your credit utilization ratio

Keeping your balance below the recommended 30% utilization rate should be a priority, and if you currently carry more than this percentage as a balance on your credit card, there are steps you can take that can almost immediately increase your credit score as a result. We cover some tips below.

1. Pay down more of your debt

First and foremost, try not to settle for making just the minimum payment on your credit card

By regularly paying down more than the minimum every month, or better yet, clearing off your balance entirely, you’ll dramatically lower your debt load and credit utilization ratio, and in turn, improve your credit score.

Even making a few small extra payments can have a profound impact on your debt repayment and credit utilization. For instance, if you owe a $1,000 balance on a credit card and only pay the minimum, it would take you nearly eleven years to pay your debt off in full. But, paying just an extra $25 every month in addition to the minimum will clear your debt in 2 years and seven months. That’s a difference of over eight years – just for an extra $25 every month. 

I know that when money is tight, every dollar counts. But if you have the financial means to do so and are set on improving your credit score, putting aside even just a dozen or so dollars extra towards your card debt every month can have a huge benefit on your credit utilization. One extra tip: try automatically scheduling payments every month on your payday to ensure some money is set aside for your credit card before you have a chance to spend it on something else.

2 Get a higher limit on your current credit card

Credit utilization deals with percentages – not dollar amounts. So, carrying a $400 balance on a credit card with a limit of $1,000 will result in a far worse credit utilization ratio than if you were to carry the same balance but with a $10,000 limit. As a result, one way to improve your credit utilization ratio is by simply increasing your card’s credit limit. 

There are a few caveats here though. For one, while credit limit increases can sometimes be applied automatically, other times, you may have to undergo a credit check to get approved for a higher limit. That can mean a hard inquiry on your credit report, resulting in a small temporary ding to your score. But again, in the long run, your score will benefit since you’ll be decreasing your utilization ratio and credit check inquiries only impact your rating for a short period of time. Secondly, with a higher credit limit, you’ll have access to more buying power. If you think that could tempt you to spend more, you may want to hold off on this option. The best strategy would be to increase your limit while maintaining or even lowering your current spending patterns.

3. Get a new credit card

The same logic covered above applies here too. 

If you open a new credit card, your total amount of available credit will go up and your debt load won’t seem as high in comparison.

If you’ve been holding off on getting a new credit card solely out of fear it would hurt your credit score, know that the impact of opening a card on your credit score is more nuanced and isn’t something to always be avoided. While your score may get a ding since an inquiry is being made on your credit report, the negative effect is temporary. Recent credit inquiries only make up a small percentage of your credit score calculation and your score can actually benefit in the long-term since you’ll be lowering your credit utilization.

When opening a new card, you’ll also generally want to leave your old credit card open even if you rarely if ever use it (to keep your utilization ratio down). Remember you don’t need to close your old credit card when making the switch to a new one.

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4. Consolidating your credit card debt with a balance transfer card

Opening a new balance transfer credit card can kill two birds with one stone by increasing your overall credit limit and offering access to lower interest rates that can help you pay your debt faster. These are both things that will improve your credit utilization ratio. But, balance transfers aren’t necessarily as straightforward compared to the other tips covered above.

Here’s how it works: you apply for a new balance transfer credit card, move over the debt on your current credit card to the new balance transfer card, and make regular payments to pay down your balance. It’s like using one credit card to pay off another.

The real advantage of balance transfer credit cards is they come with ultra-low promotional interest rates for a limited time (i.e. 0% for ten months) on the balance you transferred over. With a lower interest rate, more of your money will go towards reducing your actual balance and less will be lost to interest. In other words, you can more efficiently lower your debt load, and in turn, your utilization ratio. 

You’ll want to be cautious of a few things though. Balance transfer promotions don’t last forever, and after the offer period ends, interest rates can go up. Try to scope out credit cards that have both low balance transfer promotions as well as low regular interest rates (like the BMO Preferred Rate Mastercard) to ensure you can save on interest long-term. Also, the low promotional rate will only apply to balances you transferred over – not on new purchases you make. So, focus on paying down your debt instead of charging new purchases on your balance transfer card. Finally, aim to keep your old credit card open instead of closing it in order to maintain your total amount of available credit. 

Learn more about how balance transfer credit cards work here.

5. Try and avoid cancelling credit cards or lowering your limits

If you’ve paid down your debts and don’t regularly carry a balance of more than 30% of your total credit limits – good job! A high credit utilization rate is unlikely to affect you. That said, there is one scenario that could immediately negatively impact your credit utilization rate, and that is cancelling a credit card. Let’s look at the following example:

Let’s say you have two credit cards, both with a $10,000 credit limit. You owe $3,000 on one credit card and $0 on the other. Based on the credit utilization rate we outlined above, you’d be below the 30% threshold (15% to be exact). Now, if you decide to cancel the credit card with no balance because you no longer use it, your overall credit limit will drop, resulting in a higher credit utilization rate of 30%.

As you can see, this scenario will lower your total available credit and therefore have an immediate negative effect on your credit utilization. You can mitigate this scenario in a few ways. First, you could keep your old credit accounts open even if you rarely use it. Second, you could increase the credit limit of the credit card you wish to keep open so that the total utilization rate is still low even if you cancel any older cards. Finally, if you want to cancel a credit card you rarely use just to get out of paying the annual fee, consider calling your card issuer and asking if you could have the fee waived or switch to a no-fee alternative while maintaining your credit limit. Whatever method you choose, it’s important to try and avoid lowering your total available credit limit.  

The final word on credit utilization ratio

If you’ve pulled your free credit score and the number isn’t as high as you expected, it’s best to start tackling your low credit score using the methods mentioned above. The fastest way to give your credit score a bump is to get your credit utilization rate under 35% of your total credit limits. The other methods I mentioned above will also help, it will take more time to see results.