If you’re like most Canadians, you have some form of debt, whether that’s a credit card, line of credit, personal loan, or mortgage. And when you borrow money, you’re required to pay interest. The interest rate you’ll pay is based in large part on how risky of a borrower the bank thinks you are. You’ll generally pay a higher interest rate if you have a low credit score versus someone with a high credit score.
There are several factors that make up your credit score, including your payment history (35% of your score), credit utilization (30%), credit history (15%), credit mix (10%), and credit inquiries (10%).
As you can see, credit utilization is the second-most important factor in determining your credit score, yet many people think that as long as they pay off their credit card in full each month, how much they put on it doesn't matter. This is false! Credit utilization is a powerful thing. And managing it properly can help improve your overall credit score.
What is a credit utilization ratio?
“Credit utilization ratio” is a fancy term for how much credit you’re using out of the total amount of credit available to you. When it comes to your credit utilization ratio, the lower it is, the better.
It’s a simple thing to calculate, too. You can find out your total credit utilization ratio by adding up the balances on all of your revolving credit products – credit cards, lines of credit, and home equity lines of credit – and dividing it by your total credit limit.
For instance, let’s say you have a credit card with a balance of $2,000 and a credit limit of $5,000. Your credit utilization ratio, in this case, would be 40% (2,000 ÷ 5,000 x 100).
Why does your credit utilization ratio matter?
Your credit utilization ratio shows lenders how responsible of a borrower you are.
For example, if you regularly carry a large balance on your credit card, credit bureaus like Equifax and TransUnion, as well as lenders, will think that you may not have the financial means to fully pay it off. This means you could be more likely to run into issues paying your household bills down the line. And if you get into a situation where you’re using credit to pay for your daily living expenses and you max it out, you may have trouble covering bills in the future. All of this is a red flag to credit lenders and bureaus.
What utilization ratio should you aim for?
Equifax and Borrowell recommend that you aim to keep your credit utilization ratio below 30% at all times, while the banks say it should be less than 50% before it starts to hurt your credit score.
Borrowell recently conducted a study about the top five things that people with excellent credit scores have in common, and found that 87% of people with “excellent” scores (800-900) had credit utilization ratios of less than 30% – so we know it's an important factor! Based on our research, and to be on the safe side, we recommend going no higher than 30% of your credit utilization threshold.
How to lower your credit utilization ratio
Maybe you’ve calculated your credit utilization ratio and it’s above the recommended 30% threshold. There’s no need to panic. Here are a couple tips to help lower your credit utilization:
1. Pay down your debt
The easiest way to improve your credit utilization ratio is by minimizing the balances you carry on your revolving credit accounts. Ideally, you’ll be paying off your credit card balances in full each and every month. But if you’re having trouble making your monthly payments, you might want to think about signing up for a personal loan with a low interest rate.
Personal loans don’t affect your credit utilization ratio because they’re considered installment credit as opposed to revolving credit. With installment credit, you’re approved for a specific amount, which you agree to pay back with fixed payments over a set period of time. Interest rates on credit cards are usually greater than 19%, but are typically much lower on a personal loan, which will help you save money over the long term.
2. Up your credit limit
Another tip for lowering your credit utilization is to increase your credit limit. You can do this one of two ways: by requesting a credit limit increase with your credit card company or by applying for a new credit card altogether. But make sure you can handle the new credit responsibly. You want to increase your total available credit without adding to any debt that you might already have.
If you’re someone who always pays off their credit card balance in full every month, but your credit score is lower than it should be because your limits are too low, increasing your credit limit can be a simple solution. In fact, credit card companies will often pre-approve responsible borrowers for limit increases by sending them a letter in the mail. Otherwise, you can call and request one.
So, now you know how your credit utilization ratio is calculated. By keeping a watchful eye on your credit utilization and following the tips in this article, you can help lower your credit utilization ratio, improve your credit score, and save money with lower interest rates.