Most people need some credit for their household purchases or for major financial steps such as buying a house or a car. For that reason, you should take an interest in your credit score. The recent utilization ratio is an important ingredient in that score, and understanding this number can help you keep your credit accounts under control and your score as high as possible.
FICO Scoring
Credit scoring developed as a way to predict repayment behavior by consumers using revolving credit accounts, in which a lender allows the borrower to carry a balance from month to month, and in which the balance may fluctuate up to a credit limit. The Fair Isaac Corporation developed one method of scoring credit known as the FICO score, which ranges from 300 to 850 and is the most widely known score. Three credit-reporting agencies -- Equifax, TransUnion, and Experian -- use the FICO method as well as another calculation known as VantageScore. Several factors go into your credit score, including the number of accounts you have open, your rate of late payments, your total outstanding credit available and your utilization rate or ratio.
Recent Utilization Rates
Utilization refers to the ratio of outstanding balances to credit limits. Revolving utilization refers to the utilization rate on your revolving accounts, mainly credit cards. On a single card with a credit limit of $1,000, and for which your balance is $250, the utilization rate is 25 percent. The overall utilization rate on all your cards has an effect on your credit score, as do the single ratios on each of your accounts. Some scoring methods also take into account recent utilization -- the falling or rising utilization rate over the past six months to a year.
Optimum Utilization
In general, lower utilization rates mean higher credit scores. Many consumer agencies advise that credit-card holders should keep their utilization at 50 percent and below. Others cite 25 percent as the ideal figure. As the utilization rises to 100 percent, the risk of missing a payment or going over the credit limit increases. To card issuers, a maxed-out credit card represents a stepping-stone to a written-off account, in which the borrower fails to make any payments and the balance must be turned over to a collection agency.
Mortgages Lenders
When you apply for a mortgage, the lender will study your credit report for recent actions. If you have opened several new accounts, and your utilization ratio has been rising in the last few months, you may be turned down on the suspicion that you are taking cash advances and going into debt to come up with a down payment. The lender may also study how many of your accounts have reached the credit limit. If you hold more than one credit account, the credit agencies calculate utilization ratio in a more complicated way. The FICO score includes the utilization on the overall limit and on the individual accounts. A maxed-out card will lower the score, even if the rest of the accounts are under control and have low balance-to-limit ratios. That is why credit experts recommend keeping the utilization rate low on all your cards, keeping cash advances to a minimum and avoiding approaching the credit limit on any single card.
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