Credit Utilization Ratio: What Is It And How Does It Affect Your Credit Score?

In the wake of the recent news that America's credit card debt soared, it's time to delve into a vital concept that directly affects your financial well-being: credit utilization ratio.  

The United States has witnessed a historic milestone as its credit card debt has surpassed the $1 trillion mark for the very first time. This development raises concerns about the potential escalation of interest rates and a surge in instances of debt repayment defaults. According to various news sources citing data from the Federal Reserve Bank of New York, consumers are burdened with an unprecedented $986 billion in outstanding balances on their credit cards. This figure represents a 17 per cent surge compared to the previous year.

Similarly, as per recent data from the Reserve Bank of India (RBI), outstanding credit card balances have surged to Rs 2 lakh crore, marking a significant year-on-year increase of 29.7 per cent. As of April 2023, banks have distributed 8.65 crore credit cards. The monthly repayments for credit card dues have now crossed the threshold of Rs one lakh crore, with card-related payments reaching a substantial Rs 1.32 lakh crore during April 2023.

Here we will explore the credit utilization ratio, why it matters, and how it influences your credit score.  

Understanding Credit Utilization Ratio

Credit utilization pertains to how you use revolving credit, commonly extended through credit cards. Therefore, it centres on how much you utilize the revolving credit across all your credit cards. The greater your expenditure on your credit card, the more elevated your credit utilization becomes.

The credit utilization ratio, which is the credit utilization rate, embodies the ratio between the credit amount you employ and the sum of available revolving credit. This signifies the total credit debt you hold across all your credit cards in relation to the aggregate credit limit accessible across these cards. Typically, the credit utilization ratio is conveyed as a percentage.

How To Calculate Credit Utilization Ratio

Consider a scenario: you possess two credit cards with a joint credit ceiling of Rs 1 lakh. One card carries an outstanding balance of Rs 50,000, while the other bears no balance. The computation of your credit utilization ratio ensues from dividing the cumulative due amount across both cards (Rs 50,000 + Rs 0) by the total credit limit across these cards (Rs 1 lakh).

Consequently, the credit utilization ratio for your card manifests as (1,00,000 ÷ 50,000) × 100 = 50 per cent. Therefore, your credit utilization ratio stands at 50 per cent, implying that you're utilizing half of the complete credit allocation available. Moreover, you can perform a per-card ratio calculation for each credit card, assessing the credit utilization ratio for individual cards.

What Is Considered To Be A Good Credit Utilization Ratio

Says Adhil Shetty, CEO of BankBazaar.com: "Varying credit bureaus might adopt distinct thresholds for establishing the optimal credit utilization ratio. Nonetheless, a prevalent recommendation suggests maintaining a total credit utilization ratio that is either lower than or equal to 30 per cent."

"For example, suppose your collective credit limit across all your credit cards sums up to Rs 1 lakh. In such a scenario, the accumulated outstanding balance on all your credit cards should ideally not surpass Rs 30,000 at any given juncture," he adds.  

The Impact On Your Credit Score

Your credit score, a numerical representation of your creditworthiness, is influenced by various factors, and your credit utilization ratio is among the most important. Credit bureaus such as CIBIL, Equifax, and Experian utilize this ratio to assess your financial behaviour and determine your creditworthiness. Here's how it works:

Influence On Credit Score

Maintaining a low credit utilization ratio is crucial for a healthy credit score. A high ratio, indicating heavy credit card usage, can be seen as a red flag by lenders. It might suggest that you heavily rely on credit and could be financially overstretched. On the other hand, a low credit utilization ratio portrays responsible credit management and enhances your credit score.

Striking The Right Balance

Financial experts often recommend keeping your credit utilization ratio below 30 per cent. Striking a balance between credit usage and limits, you can handle credit responsibly without maxing out your cards. This demonstrates your ability to manage your finances prudently.

Tips To Manage Your Credit Utilization Ratio

Monitor Your Spending: Regularly review your credit card statements to keep track of your spending and outstanding balances.

Increase Credit Limit Wisely: Requesting a higher credit limit can improve your credit utilization ratio, but be cautious not to overspend just because your limit is higher.

Pay On Time: Timely payments prevent late fees and positively impact your credit utilization ratio.

In India, where the use of credit cards is steadily growing, understanding the significance of a healthy credit utilization ratio is paramount. With access to credit becoming more widespread, maintaining financial discipline becomes even more critical.

By understanding and managing your credit utilization ratio, you can take a proactive step toward maintaining a healthy credit score and ensuring your financial stability. So, the next time you swipe your card, remember that your credit utilization ratio is pivotal in shaping your financial future.