How you utilize your credit is the most critical factor in your financial wellness. Although this concept might seem straightforward initially, it determines your creditworthiness. Utilization of credit relative to the total available credit limit is called credit utilization. It is calculated as a percentage and represents the total credit limit divided by the credit card balance across all cards. With a $5,000 credit card with $2,500 in debt, your credit utilization is 50%. Now, let’s break down the formula to calculate your overall credit utilization rate:
- Overall Credit Utilization Rate = Total Credit Card Balances / Total Credit Limits
You have three credit cards: Card A with a $3,000 limit and a $1,000 balance, Card B with a $2,000 limit and a $500 balance, and Card C with a $5,000 limit and a $2,000 balance.
Your combined balances are $3,500, and your combined credit limits are $10,000.
So, your overall credit utilization rate is:
- $3,500 (balances) / $10,000 (limits) x 100 = 35%
In this example, your overall credit utilization is 35%, meaning you’re utilizing 35% of your total credit.
Why does it matter?
The use of credit is a crucial aspect of your financial health for several reasons. It significantly impacts your credit score. Credit scoring models consider your credit utilization rate when determining your creditworthiness. Generally, a lower utilization rate indicates responsible credit usage and can positively influence your credit score. Lenders and creditors review your credit utilization when evaluating your applications for loans, credit cards, or other forms of credit. A high credit utilization rate may suggest that you’re heavily reliant on credit or that your spending is close to exceeding your limits. This is a red flag for lenders, potentially leading to denied loan applications or higher interest rates if approved.
Beyond its impact on borrowing power, credit utilization also reflects your overall debt management skills. If you consistently maintain low credit utilization, it demonstrates that you’re using credit responsibly and will likely repay debts without overextending yourself financially. This behaviour enhances your financial stability and overall financial health.
How does credit utilization affect your financial health?
Now that we’ve established the importance of credit utilization let’s delve into the specific ways it influences your financial wellness:
Credit score impact
The three-digit credit score represents your credit report’s information and is crucial for your rexas financial life. Credit utilization is a significant factor in this calculation, typically accounting for around 30% of your credit score. The lower your credit utilization rate, the better it is for your credit score. For example, your credit score may decrease if you have a high credit utilization rate. It is denied favourable loan terms, higher credit limits, or competitive interest rates. Keeping your credit utilization rate low increases your borrowing power over time.
Access to quality credit cards
Credit card companies often review your credit utilization when deciding whether to approve you for a new credit card, particularly for premium or rewards credit cards with exclusive benefits. A high credit utilization rate may lead to denied applications, even if you have a good credit score in other aspects. Credit card issuers may hesitate to extend higher credit limits if they notice consistently high utilization on your existing cards. This limits your access to more prestigious cards with better perks and rewards programs, which often require higher credit scores and lower utilization rates for approval. You should always seek customized guidance from a qualified professional for financial advice.
