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.
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