Use credit responsibility to keep debt levels manageable.
Credit-reporting companies determine a consumer’s credit rating on how debt is paid down and credit is used. When creditors review an application for a new loan or card, they comb through a credit report, which features the payment history. They want to verify if the applicant was able to keep the debt accrued at a manageable level. To improve chances of approval for new credit, review balances on credit cards. You may need to lower the total credit utilization rate.*
Three things to know about credit utilization rate:
1. Definition of credit utilization rate
According to credit score provider FICO, the credit utilization rate is calculated by dividing an accounts outstanding balance by its credit limit Credit management reveals a consumer’s past and present financial standing. A credit utilization rate provides a way for lenders and other financial institutions to assess whether borrowers will be able to pay down debt.
Creditors often use this measure of creditworthiness to evaluate future repayment risk. For instance, lenders could consider it a red flag if a person continually uses his or her entire credit limit and is unable to get debt down. The higher the utilization rate, the more likely creditors will perceive the consumer as risky.
2. How to calculate this rate and which percentage to hit
To figure out what a credit utilization rate totals and whether it is too elevated for creditors, log into a credit card provider's website. Look for two pieces of information: the credit card balance and credit limit.
Calculate credit utilization by dividing the total outstanding balance by all of the cards' limits. For example, if there are four cards that have a combined balance of $3,500 and a limit of $19,000, the balance-to-limit ratio would be 18.42 percent.
But is this too high for creditors?
According to Credit Karma, try to have a maximum credit ratio of 30 percent to optimize a credit score. A Credit Karma study found consumers with scores near or in the 700s had between 1 percent and 30 percent. Do not max out a credit card. On the other hand, be sure not to let a card collect dust. The target consumers could aim for is 1 to 10 percent.
Avoid going over credit card limits by staying within a 30 percent credit utilization rate.
3. Ways to reduce and manage debt levels
By not going over credit limits, this shows future creditors that you can handle credit responsibilities and pay debts on time. Making sure debt levels are low will increase creditworthiness.
Two tips to lower debt:
Pay more than the minimum. For a credit card bill, set up automatic bill pay and allocate funds to cover more than the minimum payment each month. Ideally, pay off balances every billing cycle.
Use the snowball method. Developed by personal finance expert Dave Ramsey, the debt snowball method involves putting more funds toward one balance compared to other credit obligations, regardless of interest rates. If done right, this method helps to pay off debts faster. Ramsey suggested starting with the lowest debt balance and working to other loans to see progress.
Through paying down debt, this not only lowers utilization rate, but also increases opportunities to earn new lines of credit.
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