Two people walk into a credit union to apply for a loan. The first person has $1,000 in credit card debt. The second person has $5,000 in credit card debt. If the rest of their finances are the same, who has a higher credit score?
It’s impossible to know without more information. Why? We don’t know what each person’s total credit limits are. A person with $5,000 in debt but $50,000 in total credit limits will have a much higher credit score (if all else is equal) than someone with $1,000 in debt but only $1,500 in credit limits. That’s because of a very important credit factor called revolving credit utilization.
Revolving credit is any type of credit instrument (like credit cards, home equity lines, or personal lines of credit) where you are assigned a credit limit and can use that limit, pay off the balance, and then re-use the credit without re-applying. The opposite would be installment credit (like auto loans, student loans, or mortgages), where you borrow a sum of money once and repay it back over time.
You have many different credit scores, depending on the credit bureau being utilized and the score model (FICO, Vantage, etc.) but revolving credit utilization plays a large role in all of them.
What you need to know about Revolving Credit Utilization:
- It’s calculated as a ratio (percentage) of total revolving debts divided by total revolving limits. A lower percentage is better.
- The balance on your credit card statement is what is being reported to the credit bureau. Even if you pay off the credit card in full every month, you are still having that balance reported to the credit bureau, and this is what the calculation is made with.
- Roughly, every 1% of credit utilization paid down can increase your credit score by 1 point.
- This is the quickest and easiest way to boost your score. If you have high credit utilization, then pay it down, your score will instantly jump all the way back up. It isn’t like missed payments (which take great time to go away).
- You can improve this ratio by paying down balances or by increasing your credit limits. Be mindful of how opening new accounts can influence your credit score in other ways. The best way to increase capacity is to ask for credit limit increases on your existing accounts.
- If you don’t have at least a few credit card accounts, it may make sense to open a new account. Towpath Credit Union offers an incredibly low rate card for our members. Click here to learn more about our EverydayCredit Mastercard.
Still have questions or want to learn more? Reach out to us at firstname.lastname@example.org. We’re always happy to geek out about finance and answer your questions.