Establishing and maintaining good credit is a crucial part of building a strong financial portfolio. Even for people who are debt-averse, the habits one needs to establish credit - such as paying things on time, not borrowing large amounts of money just because you can - are ones that have a positive impact in other areas as well. While there are different scoring models for credit, as we've covered before, the FICO score remains the most well-known measurement tool.
If you're going to improve your FICO score, you need to know the ins and outs of how the information that's reported to the different credit bureaus is used to compile a score. Here is the percentage breakdown of each component of your FICO score:
Payment History: 35%
Credit Utlization: 30%
Age of Accounts: 15%
Credit Inquiries: 10%
Credit mix: 10%
While each component of your score has its own idiosyncrasies, in my opinion the most misunderstood component is credit utilization.Over the years I've seen many instances of people who pay their credit card balances off in full each month, never accruing any interest, but still have high utilization rates listed on their credit score. And because your utilization ratio is such a large percentage of your FICO score, this phenomenon can mean a person with great spending habits and payment history could still be stuck with a higher interest rate or higher payment on their debts than what they should receive. So how is this possible, and how can it be fixed? Today, we're going to break down what credit utilization is, why it's important and how to use your knowledge of how credit utilization is reported to your benefit.
What Is Credit Utilization?
Credit utilization is a ratio used to show the percentage of your available revolving credit that you've borrowed at a given point in time. Revolving credit is credit that technically has no end date or payoff date. An example would be a credit card or a line of credit; for each of these forms of debt there is a certain amount available to you that can be borrowed, but how much of that amount you actually borrow and when it's paid back is largely up to you. Debt that has a definitive payoff date, such as a mortgage or a student loan, is considered installment debt and is not included in the calculation for credit utilization.
If you have a couple credit cards that offer a combined credit limit of $10,000, the account balance you have on each card at the time the credit card companies report your balance to the credit bureau is what will be used to calculate your credit utilization. That being said, it's important to have an understanding of when these lenders do report your account balance, as it is the key to making sure your credit utilization is in a strong position when your credit is checked.
What Is A Good Utilization Percentage?
There is a rule of thumb for Credit Utilization called The 30% rule. This rule implies that as long as your credit utilization is below 30%, it won't have a negative impact on your score. It may be true that a utilization ratio below 30% is strong, but I believe a more appropriate rule of thumb would be to say that while you should make sure your utilization doesn't exceed 30%, the lower the ratio the better it is for your score. Studies have shown that many people with perfect credit maintain a utilization ratio below 10%.
Do Credit Bureaus Look At My Utilization Ratio For Each Card? Or For All Of My Revolving Debt In Total?
Yes and yes. While the many versions of FICO and VantageScore view these questions differently, the best practice is to make sure that your utilization ratio for each revolving debt you have is as low as possible, as well as the ratio for all of your revolving debt in totality. The most likely ratio you will see on your score, however, is the utilization ratio for all of your revolving debt combined. Meaning if you have $3,000 in balances reported across multiple accounts that have a total credit limit of $10,000, your utilization ratio would be 30%.
Doesn't Seem That Complicated. What Am I Missing?
The problem many people have when managing their utilization ratio is that they don't have an understanding of how and when the account balances for installment debt are reported to credit bureaus. For credit cards in particular, the difference between the amount listed on their statement balance and the amount they owe by their payment payment date can cause confusion. Let's do a quick breakdown of some key terms for credit card payments and then show you what's reported and when:
- Statement period/Statement Cycle: the period of days in which the charges you make using your credit card will be added to your bill. As an example, if you have a statement period of January 15th to February 14th, only the charges in this period will be added to your statement balance.
- Statement balance: the account balance remaining on your card at the end of the statement. As an example, if you charged $1,000 during the statement period and didn't make any payments during this time, your statement balance would be $1,000. However, if you charged $1,000 during your statement period and made $500 worth of payments to reduce your balance, your statement balance would be $500.
- Payment date: the date by which your statement balance must be paid in full to avoid interest accruing on your credit card charges. The payment date is often a few weeks after the end of the previous statement period.
- Credit limit: the maximum amount that can be borrowed on a particular line of credit.
Let's use our initial example to drive this point home, assuming the following dates:
Statement period/Statement Cycle: January 15th - February 14th
Charges made during statement period: $1,000
Credit limit: $2,000
Payments made: $0
Payment Date: March 10th
Using these numbers, the person in our example made charges of $1,000 during the statement period and made no payments to reduce their balance. On the day after the statement period closes, they would see a statement balance of $1,000. As long as the $1,000 is paid in full by March 10th, no interest would be due on the money that was charged.
What Would Their Utilization Ratio Be?
You probably think that the utilization ratio in the example above would be pretty good. After all, the charges made during the statement period were paid off in full before any interest accrued. This person should be in good standing the next time they check their credit. But remember what we said above; the credit card balance that will be used to calculate your utilization ratio is the amount the credit card company reports to the credit bureau. For many credit card companies, the account balance they report is the amount that's listed at the close of your most recent statement period.
What this means is that even if every charge you make during a statement cycle is paid in full and before your payment date, you can still have a poor utilization ratio if you have a high balance at the close of your statement period. Here's a diagram to lay out the concept:
And now let's show another diagram using the actual numbers in our example:
Even though our sample borrower did a great job of paying their charges off in full, the fact that they had a $1,000 balance reported for a card with a $2,000 limit means a utilization ratio of 50%!!!!!!!!
If these numbers were to be reported the month before they applied for a home loan, it would reflect very poorly on their score. But if they were able to pay the $1,000 in charges off the day BEFORE the statement period ended, it would mean a $0 balance reported to the credit bureaus and a utilization rate of 0%!
Small steps like these can be the difference between a sky high score when it's time to check your credit, or a low score that leads to a higher interest rate and higher payments on your new loan. By understanding and utilizing the reporting rules of your credit card company to your advantage, you can reap some of the benefits of using credit cards while also ensuring that you show a consistent pattern of holding low balances.