When it comes to personal finance (including how to get the best credit card), your credit score plays a big role. Creditors use it as a barometer for your credibility as a borrower.
One of the main factors in determining your score is credit utilization, a term not everyone is familiar with. Let’s look at your credit utilization ratio and how you can maintain a low ratio to improve your credit score.
Related: What is a good credit score?
What is credit utilization?
The term “credit utilization ratio” describes the relationship between your balance and the total credit available on revolving accounts (such as credit cards). It is the percentage of your credit limit that you are using, as reported by Three credit bureaus. Credit utilization is sometimes referred to as your “balance-to-limit ratio” as well as your “debt-to-credit ratio” — but it can also appear as “amount of debt.”
You can calculate your credit utilization with this simple formula:
- Total outstanding credit card balance ÷ total credit limit = credit utilization ratio.
Note that this will give you a number between zero and one — often multiplied by 100 to express it as a percentage.
Remember, however, that it should include all of your revolving credit accounts. So, if you have four credit cards, you’ll want to add up your balances and the total credit limit across all cards.
For example, suppose you have a combined credit limit of $12,000 on two different cards, and your credit report shows an account balance of $6,000 spread across those two cards. In this case, your credit utilization ratio is 50% ($6,000 ÷ $12,000 = 0.5 X 100 = 50%). In other words, you are using 50% of the credit limit on your account.
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You can also calculate your ratio per card using the same formula but using that specific card’s balance and credit limit. While your personal card credit ratio is important, the most critical ratio is the ratio of your overall balance to your total available credit.
Related: How to Improve Your Credit Score
How important is credit utilization?
One of the more important is the use of credit Factors that determine your credit score. Depending on which scoring model is used, it can make up as much as 30% of your score (as it does with your FICO score). The only other factor that carries this much weight is your payment history.
Why does it matter so much?
Well, from a creditor’s perspective, it can show whether or not you’re doing a good job of managing your credit cards and whether or not you’re overspending. If you consistently pay off your balance and don’t reach your full credit limit, it tells creditors (such as card issuers) that you’re a low-risk customer.
The lower your risk, the more likely you’ll be approved for cards and any additional credit needs, such as mortgages and auto loans. Plus, a higher score can unlock better terms from lenders (like lower mortgage interest rates), so paying more attention to your usage can save you real money.
What is a good credit utilization ratio?
Credit scoring models reward you when you keep your credit card utilization rate low. If you are looking for a way Boosting your credit scores, paying off your credit card balances (and therefore lowering your utilization ratio) is one of the most effective ways to accomplish that goal.
Generally speaking, you should keep your total credit utilization ratio below 30%. This is another reason why we recommend paying off your balance in full each month. This is the best way to avoid interest payments and helps keep your credit utilization ratio as low as possible.
If your credit card balance is higher than usual, the sooner you pay off that balance — even before your monthly statement closes — the better off you’ll be in terms of your credit utilization ratio.
Related: Holiday Spending Hangover: Tips to Get You Back on Track
Why canceling a card can hurt your utilization ratio
Let’s say you’ve closed a credit card with a $0 balance and a $15,000 credit limit but still have two other credit cards:
- Card #1 has a $3,000 balance and a $10,000 credit limit
- Card number 2 has a $3,000 balance and a $10,000 credit limit
With all three cards, your credit utilization ratio is 17.14% ($6,000 ÷ $35,000). However, if you cancel that card, the denominator of that equation (your total available credit) will drop significantly. Meanwhile, the numerator (your total amount owed) remains the same.
Canceling that card with a $15,000 limit will increase your overall utilization ratio to 30%.
Because of that, your credit scores can drop, even if your credit card debt is the same as before.
RELATED: How Credit Card Cancellation Affects Your FICO Score
Ultimately, the extent to which closing a credit card hurts your credit score depends largely on how many other accounts you’ve opened and how much you use them. Available credit on the canceled card can also affect this equation. However, removing at least some of your available credit lines will almost always result in a credit score drop.
To avoid lowering your overall credit limit — and thus increasing your credit utilization ratio — you have a few options when you want to cancel a card.
First, you can switch from one credit card to another. This only works if you have multiple credit cards with the same bank. Let’s say you have a credit limit of $10,000 with the Chase Personal Card, but you also have a few other Chase Personal Credit Cards in your wallet. Before canceling a card, you can call Chase to transfer your credit limit from the card — or cards — you want to cancel to your account.
This will keep your credit linked to your account, thus not affecting your credit utilization score. Once the credit is transferred from one account to another — sometimes taking up to 24 hours — you can cancel the card.
Remember, though, that every bank has a different set of rules. Typically, there’s a minimum amount of credit you’ll need to keep linked to the card — usually between $1,000 and $5,000, depending on the bank — so you’re still losing some credit, but not a significant amount. Additionally, credit shifting does not require a hard credit pull unless the new card’s limit exceeds a preset number with the bank.
Another way to avoid losing your card credit is to request a downgrade from your issuer to a different product that doesn’t charge an annual fee. This will keep your credit with the new card and have zero impact on your credit utilization score. However, downgrading a card may exclude you from applying for a new card in the future and receiving the welcome offer on that particular card.
And if the particular card you want to close is a credit card with no annual fee, you can keep it open in your sock drawer. There’s no harm in keeping it open, but you need to monitor the account to ensure no fraudulent activity occurs. We also recommend making at least a few purchases annually to avoid the issuer actively closing your account due to inactivity.
Related: Should I cancel my credit card if I no longer use it?
Applying for a new credit card
If you want to cancel a card while applying for a new card, the best practice is to apply for the new one before canceling the old card. Your existing line of credit will still be factored into your score, and your utilization ratio will be lower when your application is considered.
Related: How to Apply for a Credit Card
The bottom line
However, it’s easy to forget about your credit score when deciding to apply for a new card While enticing a welcome bonus, it’s incredibly important to keep in mind – especially your credit utilization ratio.
Debt makes up a large part of your score, so your credit utilization should always be considered when canceling and applying for new credit cards.
A lower credit utilization ratio will only help your credit score, which can lead to more favorable credit card, loan and mortgage applications in the future.
Related: 6 Simple Rules for Avoiding Credit Card Debt