The Golden Ratio of Credit

No, this is not an article about the golden ratio that’s so prevalent in nature and architecture. There will be no dissecting the number phi (φ) or explaining the Fibonacci sequence or diving into any other mysterious-sounding terms you may have heard in blockbuster thrillers about searching for hidden meanings in Renaissance works of art.   

We’ll be covering a different ratio altogether, albeit one also found just about everywhere in the world…of credit. This ratio—your credit utilization ratio (CUR), aka your credit utilization rate—is important because it determines up to 30% of your credit score.

A Way to Describe Credit Usage

Your credit utilization ratio is essentially a measurement of how much of your credit you’re actually using. More accurately, how much of your revolving credit you’re utilizing.

For most people, revolving credit consists primarily of credit cards, but personal and home equity lines of credit are also considered revolving credit. Revolving credit differs from installment credit in that it doesn’t grant you a one-time lump sum of credit the way, say, a $10,000 car loan, considered installment credit, does.

With revolving credit, you determine the amount you’ll borrow against a pre-determined credit limit—and you may keep borrowing against that limit until you hit it, so long as you continue to make consistent, on-time payments of at least the minimum amount due each payment period.

This ability to keep on borrowing and increasing your outstanding balance with revolving credit is why potential lenders are so concerned with your credit utilization ratio. Because you don’t have to re-apply for more credit with revolving credit, it’s easy to get overextended quickly. Your credit utilization ratio measures just how extended you are with an easy-to-understand percentage.

Doing the Math

Calculating your credit utilization ratio basically boils down to grade-school math, incorporating nothing more complicated than addition and division.   

CUR  =  THE SUM OF YOUR OUTSTANDING REVOLVING CREDIT BALANCES ÷ THE SUM OF YOUR REVOLVING CREDIT LIMITS

Or, in fraction format:

CUR  =  THE SUM OF YOUR OUTSTANDING REVOLVING CREDIT
           THE SUM OF YOUR REVOLVING CREDIT LIMITS

Let’s say your revolving credit consists of three separate credit cards with the following credit lines and outstanding balances:

• CARD #1: $1,000 credit limit; $300 outstanding balance

• CARD #2: $3,000 credit limit; $500 outstanding balance

• CARD #3: $2,000 credit limit; $400 outstanding balance

In the above example, the sum of your outstanding balances ($300 + $500 + $400) would be $1,200.

The sum of your credit limits ($1,000 + $3,000 + $2,000) would equal $6,000.

And your credit utilization ratio would be:

$1,200
$6,000  =  .20 or 20%.

A CUR of .20 means you are currently using 20% of your total revolving credit—currently being the operative word, for your credit utilization ratio, like your credit score, represents a snapshot in time. That’s because this ratio is fluid and continually changing, depending on how much of your outstanding balances you pay, how much of your available credit you use, and/or how much new credit you obtain.  

Targeting a Healthy Ratio

So, what’s considered a “good” CUR? From the perspective of potential lenders, the lower your credit utilization ratio, the better. This is because, to them, a low credit utilization ratio suggests a lower risk of you overextending yourself and defaulting on your debt. So logic would dictate that a 0% CUR is optimal, right?

This may sound logical, but it’s wrong. That’s because, if your credit utilization ratio is zero, potential lenders could view this as a sign you’re saving your available credit for an emergency expenditure, which might mean you don’t have enough cash on hand to pay back any credit they extended you. It sounds a bit counterintuitive, but when it comes to maximizing their odds of getting paid, creditors consider most all the angles. 

It’s better to have a positive, albeit low, credit utilization ratio. An “ideal” credit utilization ratio typically falls within the 1% - 9% range, but if that’s not doable, many experts recommend keeping it below 30%.   

Changing Your Ratio Is Basic Math

If you recall anything from studying fractions in grade school, you probably remember that changing the numerator (the top number) and/or denominator (the bottom number) of a fraction changes the fraction’s value. Given this, there are three ways to lower the fraction that is your credit utilization ratio:

SUM OF OUTSTANDING REVOLVING CREDIT
SUM OF REVOLVING CREDIT LIMITS

1.     Reduce the numerator by paying down revolving credit balances.

This will lower your CUR—but only if you do not lower the denominator (your total credit) to the point where any gain from reducing the numerator is negated. In other words, avoid closing any revolving credit accounts or decreasing credit limits in conjunction with paying down outstanding balances.

Take the 20% CUR example from above, where you owe $1,200 and have $6,000 in credit limits:

$1,200
$6,000  =  20%

If you pay down your outstanding balances by $300 and keep your credit limits the same, your new CUR would drop to:

  $900_
$6,000  =  15%

However, if you pay down your balances by $300 and close Card #2, which has a $3,000 credit line, your new credit utilization ratio goes up:

$900
$3,000  =  30%

2.     Increase the denominator by getting more revolving credit.  

Obtaining more credit through a credit line increase or by opening new sources of revolving credit will lower your CUR—but only if you do not also increase your outstanding balances to the point where any gain achieved by making the denominator larger is lost.

Using the same original CUR example, if you keep your outstanding balances at $1,200 but get a credit line increase of $1,500 on Card #2, raising the sum of your credit limits to $7,500, your new credit utilization ratio would drop from 20% to: 

$1,200
$7,500  =  16%

But, if you use your higher credit limit to purchase a new $900 smartphone and don’t pay down any existing debt, raising your outstanding balance sum to $2,100, your CUR would go up:

$2,100
$7,500  =  28%

3.     Do 1 & 2 in conjunction with each other.

This option is the most effective way to reduce your credit utilization ratio because both the numerator and denominator contribute toward lowering the fraction.

Take the same 20% CUR example and pay down your $1,200 owed by $500, so now you only owe $700. At the same time, open a new credit card with a $1,000 limit, raising the sum of your credit limits to $7,000. Your new credit utilization ratio would then drop from 20% to:

  $700_
$7,000  =  10%

Putting the Math in Motion

Once you understand the math, it’s a simple matter of applying it in order to lower your credit utilization ratio.

Of course, “simple” and “easy” aren’t necessarily the same thing.

But, as you work diligently to reduce your credit utilization ratio, you may see a bump in your credit score that motivates you to lower your credit utilization ratio even more. And building momentum plays a big role in building better credit.