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When keeping an eye on your credit score, don’t lose sight of the credit utilisation ratio

If the ratio is high and consistently so, it might indicate the individual is relying heavily on credit and may be under financial stress.

October 26, 2023 / 07:13 AM IST
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Properly managing the credit utilisation ratio is important to maintain a healthy credit score.

While most people who borrow (via loans or by using credit cards) know about credit scores, they are unaware of the concept of credit utilisation ratio.

I don’t think there is a need to explain why you need to have a good (high) credit score if you plan to borrow in the future. But since the credit utilisation ratio itself impacts the credit score, it is important to understand it.

The calculation of a credit score depends on several factors. The major ones are an individual’s credit repayment history, credit utilisation ratio, length (years) of credit history, credit mix, etc.

Let’s focus on the credit utilisation ratio now.

What is credit utilisation ratio? 

In simple terms, it simply reveals how much of your credit limits are currently being used.

Technically speaking, it is the ratio between the outstanding loan/credit card dues across all your loans and credit cards and the total credit limit—or the amount of credit you are allowed, including sums already borrowed—across all your loans/cards.

Say your credit limit is Rs 5 lakh. And you have two credit cards with outstanding of Rs 1 lakh and Rs 1.5 lakh. In this case, your credit utilisation ratio would be 50 percent (Rs 2.5 lakh divided by Rs 5 lakh).

As would be obvious from the above, the more you spend (via credit/loan), the higher will be your credit utilisation ratio.

This ratio gets a lot of importance not just to calculate the credit score but also since it gives lenders insights into the credit behaviour of the individual.

A lower credit utilisation ratio denotes responsible credit behaviour and tends to contribute positively towards the credit score. On the other hand, if the ratio is high (and that too consistently), then it might indicate that the individual is relying heavily on credit and may be under financial stress.

Also read : False declarations to avoid steep TCS could lead to penalties, warn experts 

What is a good credit utilisation ratio? 

Different credit bureaus have different good/bad thresholds. It is generally recommended that the total credit utilisation ratio be kept below 30 percent.

So, for example, if you have a total credit limit of Rs 6 lakh, it is prudent to keep your outstanding dues to 30 percent of Rs 6 lakh, i.e., Rs 1.8 lakh.

To be fair, it is fine to occasionally cross the recommended 30 percent ratio if you need to spend on emergencies or non-negotiable expenses once in a while. But a consistently high credit utilisation ratio should be a no-no. So best to try and stay below 25-30 percent most of the time. This doesn’t need reminding that you should always borrow only when it is absolutely necessary.

How to keep your credit utilisation ratio under check 

  • Always spend within your limits and not unnecessarily. Credit card expenses should be limited to amounts you can pay back in full before the next due date. Do not make the mistake of just paying MAD (minimum amount due) on your cards.

  • Just because you have a card with a high credit limit doesn’t mean you should regularly try and use it all.

  • Another way is to have your credit limit increased. So, if your credit limit is Rs 2 lakh and you regularly end up using Rs 70,000 (which is 35 percent credit utilisation and above the recommended 30 percent), the first thing is to check whether you are spending unnecessarily. And second, you can ask your card issuer for a credit limit enhancement. This will automatically lower your utilisation ratio assuming you don’t increase spending.

  • If you have multiple credit cards, don’t pile all purchases on one card and exhaust its limit. Instead, it is better to spread your expenses to maintain low utilisation ratios across all cards. Moderate spending on one card and keeping other cards unutilised for a few months is also fine.

That said, make sure you check your credit score at least once a year if you use credit regularly. As we saw earlier, properly managing the credit utilisation ratio is important to maintain a healthy credit score. So try to keep your credit utilisation ratio below 30 percent most of the time.

Dev Ashish is a SEBI Registered Investment Advisor (RIA) and Founder, StableInvestor
first published: Oct 26, 2023 07:13 am

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