How Credit Card Utilization Rate Drives Your Credit Score

pay-bills-on-timeThere was a time when paying your monthly debt payments by their respective due dates (on time) was enough to constitute good credit because your payment history was a great indicator of your willingness to repay your debts and to pay them on time. Your payment history used to account for nearly 100% of your overall credit worthiness. That all changed with the advent of credit scores.

The introduction of credit scores took the human element (emotion) out of the equation and replaced it with math (logic). Credit scoring made the question of a borrower’s credit worthiness much more complex and much simpler at the same time. It is more complex because many more pieces of information are considered to determine if a borrower is creditworthy. It is simpler because a creditor can decide if a borrower is creditworthy based on a numerical value known as a credit score.

Credit Score DiceThere are 22 individual factors that have been consolidated into 5 ‘key’ criteria that make up a credit score and paying your monthly debt payments on time is now only part of an equation. While paying your monthly debt payments on time is one of the 5 key criteria, it now accounts for only 35% of your overall credit worthiness. Another of the 5 key criteria is a borrower’s credit card utilization rate, which accounts for 30% of your overall creditworthiness.

There is a significant difference between your payment history and your utilization rate. Most people don’t know what a utilization rate is let alone that it can impact their credit scores. At least your payment history is easy to manage. Utilization rate works behind the scenes and it is not at all easy to manage.

Credit card utilization is one of the most important factors credit scoring models use to calculate your credit score while at the same time being one of the most misunderstood. Credit card utilization is the scoring formula’s way of assessing how much of your available credit is being used. The lower the utilization rate the higher the credit score.

The scoring models use two separate measures (types) of credit card utilization: 1) Individual and 2) Aggregate. An individual utilization rate is the percentage of available credit used on any one particular credit card.  To determine your individual utilization rate simply divide the current balance of a particular credit card account by that particular credit card’s high limit and multiply by 100. For example, if you have a credit card with a limit of $1,000 and your current account balance is $500, then you have a utilization rate of 50% (($500 ÷ $1,000) x 100). Anything over a 30% utilization rate can negatively impact your credit score.

The aggregate utilization rate considers the percentage of available credit used across all of your open credit card accounts. There are three steps to determining your aggregate utilization rate.

Step 1 – Add up all of your credit card balances, even if they have a zero balance

Step 2 – Add up the credit card limits of each of your credit cards, even if they have a zero balance

Step 3 – Divide the total of your current balances by the total of your credit card limits and multiply by 100

Just like it is with the individual utilization rate, anything over a 30% utilization rate negatively impact your credit score.

It is important to note that the utilization rate does not consider installment loans and mortgages.

You tend to earn points when you utilize less than 30% of your credit limit on revolving credit and begin to lose points as you exceed 30% of your credit limit.

Credit Card Utilization RateThere is NO set number of points added or subtracted from a credit score for a particular utilization rate. In other words, if your utilization rate is 0% then you receive 100 points, 1% = 99 points, 2% = 98 points, 3% = 97 points, etc… It does not work that way. The credit utilization percentage “threshold” is more like a sliding scale than a hard and fast rule and the scoring models assign points according to ranges of percentages as opposed to individual rates. For example, a utilization rate of 0% – 30% would receive maximum points for that key criteria, from 31% to 50% would receive something less than maximum points, from 51% to 75% would receive even less, 76% to 100% would lose points, and exceeding the limit (greater than 100% utilization rate) would lose maximum points.

The credit scoring models don’t like high utilization rates because it tends to indicate there’s a higher chance of a borrower not being able to repay his or her debts.

For more information on credit and credit scoring download our FREE report entitled “Credit Scoring and Wealth – The Game of Credit.”

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