Today, we will answer the question: How much credit should I have and how does credit utilization affect my score?
When I say “utilization” I am simply referring to the amount of credit that you use on a monthly basis. In a recent post I discussed understanding your score, making sure you have current and updated copies of your credit report, and understanding what a good credit score can mean for you when it comes to interest rates and approvals.
In order to understand how much credit is necessary to have on hand, you first need to understand WHY you need the credit in the first place. If you are simply looking to get a few credit cards so you can shop every now and again, that’s very simple and easily done. However, if you are an entrepreneur that want’s to start a business and is in need of access to capital for start-up and operational costs, you definitely want to have a long view of credit. When I say “long view” what I mean by this is that, your planning needs to be with the end in mind. Meaning, you need to see what your credit profile needs to look like 5 years from now.
Credit profiles that people invest in and put to work over the years can pay off greatly in the long term. For the purposes of buying a house or investing in a business this is critical. Most people won’t use credit outside of home buying or applying for business loans, but there are some individuals that make a living off of using their credit to fund other business deals, but I digress.
For now, let’s talk about what you need to win here…
You need at a minimum 2-4 good credit card accounts to begin establishing your credit history. You can have less or you can have more, but if you are considering purchasing a high-ticket item such as a home or a car you want to structure your credit properly. Purchasing an automobile has less barriers to entry than purchasing a home. So while you may be able to get away with a few deficiencies on your credit file when you are looking to purchase a car, purchasing a home won’t be so forgiving. Especially given the fact that the credit markets are still tight and banks are more stringent when it comes to qualifying for a loan. As I’ve mentioned in a previous post, I would start with a few secured cards between $250 and $500 of your own money. This is a great way to get started!
WHAT IS CREDIT CARD UTILIZATION?
Credit card utilization is defined as how much of your available credit you use on a monthly basis and is a metric often used in credit scoring algorithms. It is defined as your total open credit card balances divided by your total open credit card limits. The resulting percentage is a component used by most of the credit scoring models because it is often correlated with lending risk. Generally speaking, the higher your credit card utilization, the lower your credit scores. This is one aspect of the credit formula that you can change for the better, immediately. When you decide to pay down credit card debt this brings your utilization rates down, and your credit score higher. The utilization rate is an important indicator of an individuals lending risk. A person who constantly charges all of the money they have available to them, hitting or going over their credit limit, is far more likely to have difficulty repaying that money than a person who uses their credit cards more responsibly.
As there are dozens of different credit scoring models, it’s difficult to calculate exactly how credit utilization will impact your credit score. However, there is a strong correlation between a consumer’s credit card utilization rate and their credit score. With the exception of consumers who keep their credit card utilization at 0 percent, those who keep their utilization percentage low on average have higher scores than those who constantly max out their credit cards.
High credit utilization on a single credit card could negatively affect a consumer with little credit history and only one card far more than it could someone with multiple cards and a long and excellent credit history. This is why it’s important to use credit because positive credit behavior over time far outweighs short periods of average to good credit behavior. Credit is really a long-term strategy if you think about it.
Although it is an important factor in calculating your credit score, it is important to remember not to just focus on this one aspect of your credit score. Keep the big picture in mind.
HOW CAN YOU REDUCE YOUR CREDIT UTILIZATION?
The simple way to do this is to use no more than half of your available credit on a credit card. Another way to do this is to make credit card payments more than once a month so that your balance never gets too high. If you have more than one credit card, another good way you might lower your utilization is to use multiple cards each month. This results in various cards with low credit utilization rather than one with high utilization. Lastly, you could try to increase your available credit. If your income has increased, if you’ve maintained an amazing credit history or if you have little debt, it doesn’t hurt to ask for a credit limit increase from the credit card company. Just remember that this can sometimes result in a hard inquiry on your credit.
PROBLEM: How can you control and reduce high credit card utilization?
SOLUTION: The best answer I would give is to make good use of secured cards. Let me tell you why: If you have the ability take your own money and build up your own credit limit on your own cards you stand a better chance of stretching out your own limits that help with your card utilization. Of course, all of this will ring true given the fact that you can avoid going on shopping sprees at the turn of a dime! You are either good at using the credit that you have available to you, or you are good at getting higher credit limits. At the end of the day this all boils down to your ability manage your own credit.
THANK YOU for reading this post!
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If you are interested in our Credit Restoration Program where we consult our clients on restoring their credit profiles to align with their personal and professional goals email me now at firstname.lastname@example.org with the subject line, “Credit Coaching/Consulting Services” to schedule a 30-minute consultation. I want to START you off on the right foot in 2015!
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