If you ever researched online for the best practices related to your credit, you might have often found that one needs to always maintain a credit utilization below 30% to maintain good credit. While following this advice isn’t bad because if you did, you are not likely to make mistakes like overburdening yourself with debt, however, it does create unnecessary panic amongst individuals when the credit score drops a little. For those who don’t know, credit score is a numerical representation of your credit worthiness. Higher the number, more credit worthy you are and vice-versa. This data is used by lenders, landlords, insurance companies etc, whenever you apply for loan or any of their services to determine whether you are credit worthy enough to be trusted to repay the said loan responsibly.
One of the major factors that is used to determine the credit score is credit utilization, which is simply a ratio of the balance on the credit card that you used and the total credit limit on your card. For example, if your credit card carries a limit of $10,000 and you used $3,500 of it, then the utilization would be 35%. What you would find in most of the online research is that this number ought to be less than 30% for it to have a positive impact on your credit score and that you should never use more than 30% of the limit. That is simply not true.
Your credit score is calculated through various models like FICO and Vantage. Both have very significant weights assigned to Credit Utilization. But one should understand that it is ultimately a mathematical model. So, at whatever point the utilization is, if you pay down the balance on the card by any amount and thereby decrease the utilization, the credit score is likely to increase. For example, if you have a reported score of 650 with 75% utilization and you pay down the balance to 70% utilization, the scores are likely to increase unless there is any negative on the other factors. The extent to which the scores might increase may differ depending upon the total credit and accounts that are reporting. This is also true for the opposite. If you have a utilization reporting at 10% and you increase it to 15%, the scores will likely drop, even though the utilization would be below 30%. Now, why this is important is because people often get worried that their scores dropped because of high utilization, and that shouldn’t be the case. This is because the credit scores fluctuate based on fluctuating factors. Credit utilization is something that is in control of the individual. So, as you increase the balance, the scores drop and when you pay it down, the scores increase. If one were to miss a payment, that has a longer-term impact on the credit because Payment History also carries a high weightage in the calculation of the score.
The 30% utilization actually comes from a different context. As mentioned earlier the FICO and Vantage models are mathematical models and any change in the individual factors is reflected in the credit score proportionately as per the weights of the factors. However, when a lender looks at your credit profile if you apply for a loan, they don’t just look at the credit score. They look at your overall credit profile and generally use their proprietary algorithms to determine the result of the application, which may have different weightage to all the factors. Take hard inquiries for example. A hard inquiry would generally not have too much of an impact on your credit score as it carries low weightage in the calculation of the credit score. However, certain lenders might decline your application for recent inquiries even if your credit score is reporting over 700, because they view inquiries as potential new accounts which would likely increase your debt, thereby increasing the risk for them. It is from their point of view, a rule of thumb that if the credit utilization is reported below 30%, then they view the application positively. That only matters when you make the application, and the bank pulls your credit. But over time, this basic rule of thumb has evolved into the idea that one should never use more than 30% of their credit limit especially on the online forums. One should use as much of the limit as one is capable of paying back. But if you are to apply for a credit card or a loan, then it is a good idea to have the balance lesser than 30% of the credit limit at the time of application to secure better rates or approvals in general.