Learn why credit utilization matters if you're trying to improve your credit score.
When you're trying to improve your credit score, one of the most common pieces of advice you'll hear is to keep your credit utilization ratio pretty low.
But, what actually happens if you don't follow this advice? I recently found out, as my credit utilization ratio temporarily topped 50%. As soon as this occurred, my previously-stellar credit score fell because I was using so much of my available credit.
The impact of high credit utilization
First things first: It's important to understand what your credit utilization ratio is.
Your credit utilization ratio is calculated by dividing the credit you've used by the credit you have. If you've charged $2,000 on a card with a $4,000 limit, you can figure out the ratio by dividing $2,000 by $4,000. In this case, your 50% utilization ratio would be above the recommended ratio, as you'll need to keep this ratio below 30% to get the best score.
While I always pay off my credit cards in full every month, sometimes my credit utilization ratio is above 0% because credit card companies report the balance owed at a specific time of the month. If my card issuer reports my utilization ratio on the 15th, for example, and I pay my card off on the 20th, my credit report will show that I owe on the card. Still, because I have a lot of available credit, my utilization ratio has always been below the recommended 30% -- until recently.
In November, I charged some very expensive airline tickets and veterinary bills for my dog, which meant my utilization ratio was temporarily above 50%. I did this to earn rewards points on my purchases. But, the result was that my score, which was 779, fell to 747.
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This drop came despite the fact that nothing else changed and despite the fact that I had several other cards with tons of credit available and $0 balances. Topping a 50% utilization ratio on this one card alone was enough to send my score down over 30 points.
Does a 30-point drop in your credit score matter?
A drop of 30 points on a credit score may not seem like much, but it can sometimes be enough to send you into a different risk tier, depending upon where your credit score started. If you had a score of 740, for example, your credit would be classified as "very good." But, if that score dropped to 708, you'd only be in the "good" range.
Dropping down to a riskier tier means interest rates may be a little bit higher than they otherwise would've been. Had I been applying for a mortgage or a car loan after my score fell, my almost-maxed out card might have cost me thousands of dollars over the long term.
Depending where your score was when you started, a drop of 30 points could potentially mean the difference between being approved for a loan or being denied.
How to avoid a big drop in your credit score
The only way to avoid hurting your credit score by using too much of your available credit is not to use more than 30% of your credit line on any credit card. Ideally, getting this utilization rate as low as possible is ideal.
If you make a big purchase, as I did, you can actually pay off the amount you charged before you get your statement -- and before the credit card company has a chance to report your high utilization ratio to the credit reporting agencies. If I charge so much on my card again, I'll be taking this approach.
Even if you don't pay off the card immediately, paying it off ASAP is imperative because when your utilization ratio comes down, your score will go up again. I've since paid off my card, and my credit score in December jumped right back up to where it was before.
Credit utilization matters
It's clear from my big credit score drop that credit reporting agencies really do care about credit utilization, even when you're an otherwise responsible borrower. Since a high utilization ratio makes so much of an impact, it's important to avoid getting close to maxing out your cards -- especially if you'll be taking out a big loan in the near future.
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