What is a credit utilization ratio?
There are many elements that make up your credit score: your payment history, the length of your credit history, how many types of credit products you have, recent credit inquiries and, one of the most important, your credit utilization.
Your repayment history makes up the biggest chunk of your credit score, at 35 per cent. Credit utilization comes in second place, but not by much, at 30 per cent. (The other three elements each account for 15 per cent or less of your score.)
"Credit utilization refers to the ratio of credit you're using out of your full available credit limit," says Heather Battison, vice president of TransUnion, one of Canada's two credit reporting agencies. "This includes all lines of credit, including credit cards, loans and revolving debt."
Battison says credit utilization is so important because it lets lenders know how well you use and pay down debt.
"If you're utilizing the majority of your available credit, you can appear risky to lenders who may question your ability to pay back your loans," she says. "Conversely, low credit utilization is an indication that you're a responsible spender and can appropriately manage your debt."
What is a good credit utilization ratio?
Most credit counsellors will tell you it's important to pay off your credit card balance each month to keep your debt in check and spend within your means. This will also prevent you from paying interest.
Of course, emergencies happen, and it's not always possible to pay off your entire balance each month. As far as lenders and credit reporting agencies are concerned, as long as you're not maxing out your credit limits, you can still be a safe bet.
TransUnion advises using less than 35 per cent of your total available credit. So, if you have $1,000 in available credit, whether it be on one card or split between two, you shouldn't carry more than $350.
However, Equifax, Canada's other credit bureau, suggests keeping your credit usage below 75 per cent of your available credit.
When in doubt, just try to keep the ratio low -- the lower, the better
Credit card issuers report balances to credit agencies monthly, but not all lenders report balances on the same day (so, don't rely on, say, the first of the month or the last of the month). This means credit balances may not always appear as you expect them to when you apply for new credit.
Should you apply for a new card to lower your
You may be tempted apply for new credit to increase your overall available credit limit and lower your credit utilization. This strategy may work to a certain extent, but as always, you need to exercise caution.
"It's important to pay off existing debt and demonstrate financial responsibility to lenders before applying for a new card and taking on added debt," Battison says. If you're using too much credit already, you may not even be approved for the new card.
Each application for new credit will create a "hard inquiry" on your credit report, which can temporarily lower your score. Each hard inquiry puts a minor ding in your score, but too many at once makes you look desperate for credit, and like a high risk to lenders, Battison says.
"A flurry of inquiries will prompt most lenders to ask you why" you you want the credit, the Equifax website states. So don't think you can apply for several cards and shrink your utilization without repercussions.
It's also not wise to keep adding more credit to your wallet if you are already spending close to your limit and not paying it down. Even if you tell yourself you won't use the new card, the temptation could be too much, you'll run up your credit utilization, and you could end up in an even deeper debt hole.See related: 5 surprising ways you can sink your credit score, Watch out for these 7 mistakes when applying for a credit card, Why and how you should ask for a credit limit increase
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