I've had the honor of doing our student loan workshop for 50+ DPT programs through out the country. One common question that I consistently receive is...How do I increase my credit score? A good credit score is important because you can get a better interest rate in the future when you get a loan such as when you graduate and want to refinance your student loans.
There are many ways to increase your credit score. However, in my opinion, one of the most effective ways is to develop a strategy to manage your credit utilization ratio. This article discusses what the credit utilization ratio is, questions that arise about the ratio, a strategy to maximize your credit score by effectively managing this ratio, and a secret not known by many about the credit utilization ratio that can really increase your credit score or harm it (YOU’LL WANT TO READ THIS IF YOU OWN A HOME).
What is the Credit Utilization Ratio
The credit utilization ratio is the amount you have borrowed relative to how much available credit you have. The ratio primarily concerns revolving credit, i.e. credit cards, so that is what we will highlight today.
For example, if you have a single credit card with a credit limit of $10,000 and you have $1,000 outstanding then your credit utilization ratio is 10%.
Popular Questions About the Credit Utilization Ratio
Question 1: Is the credit utilization ratio calculated on the combined limit of all my credit cards or on an individual basis?
Answer: Both but the focus is on the combined limit. For example, if you have two credit cards that both have limits of $10,000 then your credit score is primarily affected by your combined balance outstanding on both your cards. For example, if you have a balance of $1,000 on one card and $0 on the other card, then your ratio is 5% (1,000/20,000). With that said, your credit score will be affected if you have a high balance on one of the cards but to a lesser degree.
Question 2: How high can my credit utilization ratio be before my score becomes affected?
Answer: No one knows…the actual algorithm that calculates your score is a trade secret. However, the general rule of thumb is to not go above 30%. I personally tell people not to go above 20% and if they can help it not to go above 5%. The good news is that with the advent of technology, you can go onto most credit cards websites and set alerts to tell you when you hit the given percent you do not want to go over.
Question 3: What balance outstanding is used to calculate my credit utilization ratio?
Answer: The amount reported to the credit bureaus. Most credit card companies report your balance and payment activity to the credit bureaus once per month. However, this doesn’t necessarily coincide with when your bill is due. If your credit card company reports a few days before the end of your billing cycle, you will look like you are carrying a balance REGARDLESS IF YOU CONSISTENTLY PAY OFF YOUR CREDIT CARDS ON A MONTHLY BASIS.
This can be solved by placing a call to your credit card customer service line and asking when they report to the credit bureaus. Pay off as much of your balance as you can in advance of that date every month.
Only the amount outstanding on that one day per month is reported. This mean you can charge a purchase, pay it off, charge another purchase, and pay that off. If this was done before the reporting day for that month, you would show a $0 outstanding balance.
Effectively Managing Your Credit Utilization Ratio To Maximize Your Score
The following strategy is one I personally implemented when I was 25. If you follow these steps you should be able to have a combined credit limit over $100,000 within a couple of years. This helps you financially. For example, if you have an emergency expense, let’s say $2,500 for car repairs, you can put it on your credit card and the affect will be minimal because your credit utilization ratio will only be 2.5%.
Step 1: Open a credit card. This should be your “primary” credit card you use and payoff on a monthly basis. Choose wisely as this should be the one that will maximize your points and rewards.
Step 2: Open a new credit card once a quarter for two years. Yes, each credit card you open will slightly affect your score but the long run benefit, in my opinion, outweighs the short-term hit. However, if you know you will need a loan such as a car loan, open the credit card after getting the loan. Also, these are your secondary cards so make sure you are not paying annual fees on them. Also, you should look into cards that give you a good amount of points upon opening the card (Check out this new site for more info).
Step 3: Use only your primary card for monthly purchase. Once every six to nine months make at least one small purchase on your other seven cards. If you do not do this the credit card company will most likely close your account and this will hurt your score.
Step 4: Call your credit card companies every one to three years and ask them to increase your credit limits.
A Secret About the Credit Utilization Ratio
If you own a home, there is a secret that can either really help your credit score or potentially harm it. There are two primary ways credit is reported, either as an installment loan or a revolving credit. An installment loan is something like a mortgage. Revolving credit is a credit card.
When you own a home you can go to a bank and ask for a home equity line of credit (HELOC). One thing that people often do not realize is that a HELOC IS NOT A LOAN. It is not the same thing as a second mortgage. It goes on your credit report as a revolving line of credit, i.e. like a credit card.
Therefore, if for example you have a $40,000 HELOC and 100% of it is being used, that is reported on your credit report the same way as a maxed out credit card. This has to be factored in when looking at your credit utilization ratio.
However, if you own a home and have equity, a HELOC can help your credit. Say you have $50,000 in equity in your home. You go to your bank and ask for a HELOC and they approve you for $20,000. That does not mean you have to withdrawal the $20,000 right then, or ever. What it means from a high level is that you have a credit card with a limit of $20,000 that is backed by the equity in your home. Since you are not actually using the money, you will show a zero balance each month and help your credit in the long run. Plus, you will have access to $20,000 should you need it in a dire emergency.