Credit Utilization Ratio – The Credit Score Factor You May Be Overlooking

Jordann Brown
by Jordann Brown December 26, 2018 / No Comments

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

But what is a great credit score? Your credit score is a number between 300 and 900, and it measures your creditworthiness. If your credit score is 650 or higher, it is considered good. If it’s 750 or higher, it’s considered great. You can check your credit score online for free, and if your credit score is a few points below that threshold, don’t panic. There are many ways to improve your credit score.

How your credit score is calculated

Before you can start improving your credit score, you need to understand how credit reporting agencies calculate it. Two organizations are responsible for compiling credit scores in Canada: Equifax and Transunion. These organizations take many factors into account when calculating your credit score, including your:

  • Payment history
  • Length of credit history
  • Types of credit
  • Number of recent inquiries
  • Credit utilization rate

To improve your credit score, make all of your payments on time, keep your oldest credit account open, have some different types of credit, and don’t apply for too many different credit cards at once.

Finally, you 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 today 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 your balance is $3,000, your credit utilization for that product is 30%.

It’s recommended that you keep your credit utilization under 35% 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 shouldn’t have a cumulative balance of more than $7,000.

Why does credit utilization matter

The major credit reporting agencies set the 35% limit on your credit utilization because, to them, anything over that is a red flag that you may be in more debt that you can comfortably pay off. Carrying a balance over 35% of your credit limit signals to them that you are a higher risk. This is the case even if you pay off your balance at the end of every month.

Keeping your balance below the recommended 35% utilization rate should be a priority, and if you currently carry more than this percentage as a balance on your credit card, you should make a point to pay it off soon. You’ll see your credit score start to increase almost immediately as a result of paying down your debts.

Cancelling credit cards and your credit utilization rate

If you’ve paid down your debts and don’t regularly carry a balance of more than 35% 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 have $3,500 on one credit card and $2,000 on the other, for a total balance of $5,500. Based on the credit utilization rate we outlined above, you’re below the 35% threshold ($5,500 / $20,000 = 27.5%). Now, if you no longer need one of these credit cards and you decide to do a balance transfer and cancel one of your credit cards, your overall credit limit will drop, resulting in a higher credit utilization rate ($5,500 / $10,000 = 55%).

This type of transfer and cancel scenario will have an immediate negative effect on your credit score. You can mitigate this scenario a few ways. First, you could transfer a balance but keep your second credit account open until you pay down the balance to within acceptable levels. 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 one of the credit cards. Whatever method you choose, it’s important to keep your credit utilization level low, to maximize your credit score.

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The final word on credit utilization rates

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.