Why Maxing Out Your Credit Cards Can Hurt Your Credit
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Paying your bills on time is one of the best ways to raise your credit score. The second-best way toward a higher credit score is one you may not understand or have even heard of: credit utilization.
It measures how much of the available credit on your credit cards is used. It also accounts for 30% of a credit score. Payment history is the most significant factor in determining a credit score, accounting for 35%.
Understanding your credit utilization rate, generally expressed as a percent and is also called a credit utilization ratio, can help you know how to raise your credit score, build credit, and maintain a good credit utilization ratio.
Higher credit scores can make it easier to qualify for other loans at favorable terms, including auto and home loans and additional credit cards.
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What is credit utilization?
A credit utilization rate measures how much revolving credit you’re using. A lower ratio is seen by creditors as good and shows you’re watching what you spend. In comparison, a higher ratio can lower a credit score because it’s seen as an indicator of spending too much of your credit limit and can be a sign of financial distress.
A credit utilization ratio is calculated by dividing the amount of revolving credit on your credit cards that you’re using by the total amount of revolving credit available to you. It’s the amount you owe divided by your credit limit.
Suppose you have $10,000 in available credit on one credit card. It’s the maximum amount the credit card company will let you borrow in a month. If you have a balance of $3,000, then your credit utilization rate is 30%. Divide $3,000 by $10,000, then multiply by 100 to get the percentage of credit you’re using.
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But that’s just the ratio on one credit card. You might have a high ratio on one card and a low one on another. The higher one will hurt your credit score while the low one won’t, but the overall ratio will also affect a credit score.
With two or more credit cards, you should add up the credit limits on all of your credit cards, also called your available credit. Then add up your current credit card balances. Divide your debt by your credit, and you’ll have your total credit utilization ratio.
From the example above, with a 30% utilization rate, your overall credit utilization ratio will increase if you add a credit card with $5,000 in available credit and a balance of $2,500. On the second card, the rate is 50%, meaning you’re using half of the available credit on the card.
But add up the numbers on both cards, and the results change. With a total balance of $5,500 and $15,000 in total available credit, you divide 5,500 by 15,000, multiply that sum by 100, and get a credit utilization ratio of 36%.
Credit card | Credit limit | Outstanding balance | Credit utilization ratio |
Card X | $10,000 | $3,000 | 30% |
Card Z | $5,000 | $2,500 | 50% |
Totals | $15,000 | $5,500 | 36% |
What’s a good credit utilization ratio?
Doing the math of dividing your credit card balances by available credit is just the beginning. You next should know what that number means with a ratio in hand.
A good rule of thumb is that credit monitoring services and creditors prefer a ratio of 30% or less as ideal. A credit score by VantageScore or a FICO Score usually recommends a total credit utilization rate below 30% as an indicator that you’re managing your credit responsibly and not overspending.
A higher rate can signify to potential lenders that you have high credit card balances and don’t manage your money too well. A high credit utilization rate could signify impending default on a loan.
Effect on credit scores
Credit reporting companies such as Experian consider five factors in determining a FICO Score:
- Payment history: 35%
- Credit utilization: 30%
- Credit history: 15%
- Credit mix: 10%
- Credit inquiries: 10%
Late payments have the most significant impact on a credit score, but a credit utilization ratio is the next-biggest. Paying your bills on time and not using more than 30% of your credit limit can give you a good credit rating. The less of a line of credit you use, the higher credit score you can have.
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Scores and utilization rates change monthly
Every month you have the chance to raise your credit score. A credit utilization rate changes each month as you pay off your credit card bill — or don’t.
Credit card companies typically update the balance information they send to credit monitoring services every 30 days when a billing cycle ends. If you pay off one credit card or all of your credit card balances, and you may not see an impact on your credit score for a few weeks.
Again, utilization rates can change monthly, depending on how much credit you use. Making a lot of credit card charges without paying them off entirely in a month or so, and your ratio will likely rise.
Credit utilization rates are only based on revolving credit, such as credit cards and lines of credit. They aren’t based on installment loans such as a mortgage or auto loan.
Revolving credit doesn’t have an end date. It carries over from month to month — unless you pay it off in full. You can borrow against your credit limit every month until you reach that credit limit. Pay down the balance, and the amount of credit available rises again. An interest rate is charged on the revolving balance.
How to lower your credit utilization ratio
There are some smart – and not-so-smart – ways to improve your credit utilization ratio.
You might think that adding a new credit card and thus increasing your available credit will raise the ratio by giving you a bigger number to divide your credit card balances by. Or you may want to close a credit card account so that you have less available credit to tempt you to use.
Both of those choices can hurt your credit utilization rate, which we’ll explain soon. Here are ways to lower your credit utilization rate and hopefully impress the credit bureaus.
Pay off balances
After paying your bills on time, the best way to raise your credit score quickly and lower your credit utilization rate is to pay off your credit card balances.
Paying off a credit card balance lowers the utilization rate to zero. Besides reducing your debt, paying off credit card balances is like giving yourself an interest-free loan because credit cards don’t charge interest if the monthly bill is completely paid off by the due date each month.
Even if you can’t get to a zero balance each month, or your total balance for all of your credit cards isn’t zero, keeping them as low as possible can improve your credit score and credit utilization ratio.
Open a balance transfer card
If your credit card balances are so high that you can’t afford to pay them off each month, or can’t lower the balances by much, then you may want to consider a balance transfer credit card.
You can consolidate debt by transferring a balance from a high-interest credit card to one with low or no interest. You should then be able to afford bigger payments.
Opening a new line of credit can lower a credit score for a while, but it also increases the amount of credit available to you. Your credit utilization ratio can drop if you don’t use the card to buy more things instead of paying off the new, combined balance.
Ask for a credit limit increase
Ask your credit card provider for a credit limit increase as another way to see your credit utilization rate improve. It’s simple math. Having a higher amount of available credit means you now have more money that you’re not using, and your credit utilization ratio will drop.
If you have a $5,000 balance on a credit card with a limit of $10,000, your credit utilization ratio is 50%. Add $5,000 to your credit limit but don’t increase the balance, and the credit utilization ratio drops to 33%.
The key, obviously, is not to use the extra money available in the line of credit increase.
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Options with potential downsides
Two ways of possibly reaching a low credit utilization ratio can backfire, though the downsides may be worthwhile in the long term.
Open a new credit card
Instead of getting a credit limit increase on a credit card you already have, you can apply for a new credit card with its own spending limit.
This increases the amount of total available credit, which will lower your overall credit utilization rate and thus your credit score. The caveat, again, is not to use this extra amount of available credit.
A new credit card also adds to your credit history, which makes up 15% of your credit score. The longer you have credit cards, the more it will help your score.
A downside is that opening new credit accounts can hurt your credit score in the short term. New creditors can hurt your credit history because the new accounts shorten the average time that you’ve kept accounts open. Applying for a credit card also results in a new credit inquiry, which can hurt your score for the short term too.
If you have too many credit cards, it can hurt your credit mix and be seen as a risk factor that you need the extra credit to survive financially. Having higher credit limits can also be tempting and can increase your debt. It’s good to have different types of credit.
Close a credit card
Paying off a credit card balance and then closing the card account can seem like a smart thing to do. With one less credit card tempting you to spend, you can eliminate some of your debt and hopefully avoid more credit card charges.
But closing a credit card usually won’t improve your credit utilization rate, and it could drop your credit score in a few areas.
Closing a credit card reduces your total credit limit. If you keep your overall credit balance the same, your credit utilization rate will increase because there will be less available credit to divide the balance into.
Your credit history will also take a hit because you’ll now have one less account to add to the average age of your accounts. Closing a credit card you’ve had for years can hurt your credit score in just about any credit scoring model.
Pros and cons
Pros
- Computing your credit utilization ratio can help you see where your credit score may be headed. A rate above 30% could mean you’re using too much of your available credit, and your credit score could drop.
- Credit utilization accounts for 30% of a credit score, so it’s worth paying attention to.
- Paying off credit card balances is the best way to lower your credit utilization ratio.
Cons
- You may not see any credit score improvement for a month or so after changing how much available credit you use.
- Opening another credit card, paying down balances, and getting a credit limit increase, among other methods, can help lower a credit utilization rate. Still, those efforts can be negated by adding more charges to a credit card.
- Micromanaging your credit utilization rate can be futile if you’re not paying your bills on time since payment history is the biggest factor in credit scores.
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The bottom line
If you can afford to pay off your credit cards, you should. You’ll not only eliminate debt, but you’ll raise your credit score by lowering your credit utilization ratio.
It’s a simple computation to learn and can help keep you from overspending by knowing how it affects your credit score. And with a better score on your credit report should come better loan terms over time.
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Writer
Aaron Crowe is a freelance journalist who specializes in personal finance writing and editing. He has worked at newspapers, where he won a Pulitzer Prize, and has written for numerous online publications. These include AOL, US News & World Report, WiseBread, Bankrate, AARP, and many websites focusing on housing, credit and insurance. He lives in California with his wife and daughter.
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