How Does Credit Utilization Affect Your Credit Score?

Credit Utilization refers to the portion of your credit limit that you spend in each billing cycle. If your credit limit is Rs. 100, it doesn't mean that the entire money is yours to spend. What if you can't afford to repay? What if you are overspending without reason? A borrower is expected to be mature and spend responsibly.

Your credit utilization rate reflects your spending habits, and thus credit bureaus treat it as an important determinant while calculating your credit score.

If you wish for a good credit score, you better keep your credit utilization rate healthy. Most financial advisors say that a credit utilization of 30% and below is ideal for your credit health. Read on to know more.

How to Calculate Credit Utilization

Let's say that you have a credit card with a credit limit of Rs. 1,00,000. You have made a purchase worth Rs. 30,000 using the same credit card. The ratio between these two is your credit utilization. To put it lucidly, it refers to the amount or percentage of your credit limit that you have used. In this case, it is 30%. Here is how you can calculate your credit utilization:
(30,000/1,00,000) * 100 = 30%
In case you have multiple credit cards, you can add the balances in each card to get your total credit balance. Similarly, add the credit limit on each card to get the total credit limit. Now apply the formula to these new numbers to find your overall credit utilization rate.

Why Does Your Credit Utilization Affect Your Credit Score?

Lenders refer to your credit score to judge your creditworthiness. Credit utilization being a valid indicator of the same, it affects your credit score. Your credit utilization rate indicates if you are a lending risk. According to the lenders, if you exceed your credit limit regularly, you are more likely to have difficulty repaying the money. However, if you spend less and pay off your balance in full every month, lenders will consider you to be more reliable with credit.

How Does Your Credit Utilization Affect Your Credit Score?

Low credit utilization is the best way to maintain a high credit score. It shows that you are keeping your expenses within limits by using a small amount of credit. A low utilization rate, not exceeding 30%, is considered best for your credit score.

The credit utilization ratio in each of your credit cards is taken into account by the credit bureaus to determine your credit score - individually as well as collectively. All these can make the calculation quite complicated. You can always try mymoneykarma’s Intelligent Finance Tool for regular tracking.
A high rate of credit utilization will bring down your credit score. It indicates that you are overspending and might not be able to pay your bills on time. If you don't manage to repay on time, a high rate of interest is applied to the principal borrowed amount. So you would be paying more than you had actually borrowed, and your funds will gradually deplete. In the long run, your pocket will have way less money.

How Do You Reduce Your Credit Utilization Rate?

You could follow these simple steps to reduce your credit utilization rate:

Pay Your Credit Balance More Than Once a Month

The credit card issuing companies typically report your credit balance to the credit bureaus at the end of your billing cycle. You need not be worried about how much you are spending each month. If you pay a part, or preferably all, of your outstanding balance before the issuing companies report your credit balance, your credit utilization rate for the concerned cards will remain low.

Paying the balance in full each month positively impacts your credit score. It also shows that you can borrow money responsibly and stay within the limits of your affordability. It makes you a creditworthy borrower in the eyes of a lender.

If your credit utilization rate tends to shoot up, you should try to balance it by making multiple payments each month. Reduce your credit utilization rate as much as possible - preferably below 30%, which is considered healthy for your credit score.

Let's say your credit limit is Rs. 1,00,000. You have spent around Rs. 50,000. The card issuer will report your credit utilization at 50% in your monthly statement, bringing down your credit score.
However, if you pay off Rs. 25,000 before the statement is generated, your credit utilization will be reduced to 25% in your statement, thereby boosting your credit score. Before you proceed with this strategy, you must get in touch with your card provider and find out when exactly they report your information to the credit bureaus.

Spread Your Expenses across Multiple Credit Cards

If you have multiple credit cards, you can maintain multiple credit accounts of low credit utilization. This is more profitable for you than a single account with high utilization

Let's say your monthly credit card expense is Rs. 60,000. You have a single credit card with a credit limit of Rs. 1,00,000. It means that your credit utilization rate is above 50%, which is harmful to your credit score.
You could solve this problem by taking two more credit cards. Your total credit limit would then add up to Rs. 3,00,000. Spend from all of them, ensuring that you don't cross your monthly quota of Rs. 60,000. Your credit utilization rate will thereby drop to 20% for each of your credit cards, which would not affect your credit score negatively.

Increase Your Credit Limit

A higher credit limit automatically brings down your credit utilization rate, provided that your expenditure or credit balance remains constant.
You may call your credit card issuing company and request for an increase in the credit limit, or make an application online. However, increasing your credit limit isn't a piece of cake, and you might have to go through a rough road.
There might be certain requirements that you need to qualify to get more credit limit. You could be required to have maintained your account for a specific period; your payment history might be scrutinized; and your credit score must be good enough for a raise in credit limit.
At the same time, this request might be treated as a hard inquiry even if it remains unapproved. The inquiry itself could slightly reduce your credit score. You need to assess your chances carefully before making a decision regarding this aspect.

To Sum Up

You need not carry an outstanding balance or pay interest every month to ensure that your credit utilization is optimum. Using your card within a limit shows activity, and settling your balances every month shows responsibility.
That's all you need for a good credit score. Make sure that you check your credit score regularly to keep track of your progress as well.