A Lesson in Credit Utilization


A friend of mine recently notified me that his credit score plummeted nearly 100 points from the last time it was updated.

He is enrolled in a free credit monitoring program, so he receives alerts when his credit scores fluctuate.

Naturally, I asked him why he thought his credit score could have dropped so dramatically in such a short period of time.

He was quick to explain that he hadn’t paid any bills late, and that nothing negative was being reported on his credit report.

We dug a little deeper and he began to tell me about some recent large purchases he had made on several of his credit cards.

It turns out he spent about $15,000 in the matter of a couple weeks, which was nearly 50% of his total aggregate credit line (all credit card limits combined) of roughly $30,000.

Bingo! That was the problem. He essentially used up half of his available credit in a matter of weeks, a big red flag to his creditors and the 3 major credit bureaus.

Think Like the Creditor

  • Pretend for a moment that you’re the bank or credit card issuer
  • And a friend of yours ask to borrow money from you
  • If they already have a bunch of outstanding debt you might be reluctant to lend to them
  • But if they’re debt-free you might be more open to the idea

Imagine if you knew someone who was going around asking people to borrow money for a new investment. And that someone had already borrowed $15,000 from five other people.

There’s a good chance you’d be less inclined to offer that someone money knowing the person already had $15,000 in outstanding debt.

That’s the same way creditors think, and the reason why credit bureaus depress the credit scores of borrowers with high amounts of outstanding debt.

In fact, 30% of the FICO score algorithm is based on “credit utilization”, which relates to the amount owed on accounts, number of accounts with balances, and proportion of credit limits used.

When my friend went on that spending spree, other potential creditors were given a kind of warning to limit new credit in the form of a much lower credit score.

This was based on the assumption that someone with a greater amount of debt will be less likely to pay back additional debt that is accrued.

25% May Be the Magic Number

  • You might wonder what is the right amount of credit utilization
  • Obviously you’ve got to use your credit cards so you can’t keep them at zero constantly
  • For FICO scores a utilization of 25% or less might be the ticket
  • For VantageScore it might be best to keep balances below 30%

The big question is, “How much is too much?” FICO doesn’t reveal everything about their scoring algorithm, but they did note once that those with the highest credit scores tend to keep their “credit utilization ratio” below 25% on their credit cards.

So if you’ve got a $10,000 credit card limit, keeping it below $2,500 may be best, as far as your FICO score’s health is concerned.

As far as VantageScore goes, they say the rule of thumb is to keep balances below 30% of the credit limit on any given account.

In our preceding example, that would mean keeping balances below $3,000 on a $10,000 limit.

Clearly my buddy didn’t adhere to either of these rules, and his credit scores suffered big time as a result.

Playing the Credit Card Utilization Game

It’s also important to note that credit utilization is measured via individual credit cards along with your overall aggregate credit limit.

For example, let’s say my same friend has five open credit cards.  His total credit limit is $30,000 and he’s using $15,000 of it.

– Credit Card A: $5,000 limit, $4,000 used
– Credit Card B: $10,000 limit, $9,000 used
– Credit Card C: $2,000 limit, $0 used
– Credit Card D: $7,000 limit, $0 used
– Credit Card E: $6,000 limit, $2,000 used

We already know he’s using 50% of his total available credit, which we’ve determined is bad news.

But he’s also using 80% of his total credit line on Credit Card A and 90% on Credit Card B. That’s also not good.

He has two cards open that aren’t being used, which helps his overall ratio. These should stay open to keep his credit scores from tanking even more.

After all, if he closed them he’d lose $9,000 of his $30,000 aggregate credit limit, and his overall credit utilization would rise to nearly 72%.

For the record, you can also get dinged for having too many credit cards with balances over zero dollars, so keeping those cards open and at $0 is helpful as well.

As you can see, it’s tricky to keep balances low and utilization rates down across multiple cards without triggering some kind of penalty from the credit score makers.

You’ve Got to Tackle the Credit Card Debt Eventually

The takeaway is that he’ll need to eliminate the debt as opposed to shuffling it to improve his credit scores.

And though his credit score was dinged because of his recent spending spree, over time his scores will rise back up as long as he sheds the debt and makes timely payments.

[Carrying a balance doesn’t help your credit score.]

In other words, it’s really just a temporary depression, but one that can cost you a significant amount of money if you apply for new credit or important loans around the time of the drop.

That’s why it’s imperative to avoid large purchases before and during important transactions such as auto leases/loans and mortgage loan applications.

You won’t want bad timing to hurt you in any way, especially if it means a higher interest rate (for years to come) or an outright declined application.

Keep an eye on your debt and make sure it stays below the key levels mentioned above, and never max out your credit cards!

Sure, there will be times when you need to make sizable charges on your cards, but work on knocking those balances down as quickly as possible to ensure your credit scores stay in tip-top shape.

Read more: How to raise your credit score.

(photo: procsilas)

By Colin Robertson

Colin created this blog after spending several years in a job that required him to scour credit reports on a daily basis. His goal is to help individuals better understand their credit and get the most out of credit cards.

1 comment

  1. Interesting…my utilization rates were super high and my credit scores were super low…once I paid everything down my scores went up about 100 points each. And I didn’t have any late payments or anything bad. Amazing how high balances alone can crush you.

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