If you eventually want to borrow enough money to finance a house or an automobile, then its vital that you establish good credit. Using credit cards in a smart way is one of the best ways to establish good credit. Sadly, many people are not taught sound credit card utilization strategies, and unfortunately, end up in untenable financial situations.
If you are new to the world of credit, credit cards, and credit card utilization, then continue reading for an overview on how credit card utilization can impact your credit score, and why all of this is so important.
What Is Credit Card Utilization?
People with jobs or evident money to spend are enticed by credit card companies to open a line of credit, usually in the form of a credit card. This is the introduction to credit line management for many people. Meanwhile, other people begin applying for credit cards as soon as they are able to in order to finance purchases that they can’t cover with cash.
As purchases accrue on a credit card or line of credit, a card’s available credit begins being used up. The percentage of available credit relative to the limit on a credit card or line of credit is referred to as credit card utilization. In short, credit
utilization refers to the amount of available credit a consumer has used against the limit on her or his respective credit card or account.
For example, a credit card with a limit of $500 that has $200 in purchases on the account would have a utilization rate of 40%. Per most of the credit card bureaus and issuers, an optimal credit card utilization would be around 40% or less. Keeping your utilization rate fairly low – meaning that you have a good amount of available credit – is one of the strongest ways to build your credit score and entice lenders to make better offers with lower APR. This will be discussed more below.
A good credit score is the key determinant in future lending. If you eventually want to take out a home loan or another large lender-issued loan, a good credit score greatly enhances your likelihood of being approved.
Why Is Credit Card Utilization Important?
As mentioned above, credit card utilization is important because it’s the primary measurement most lenders use when determining future lending offers. The best way to inspire banks and credit card companies to make future lending offers is to keep active credit cards or accounts with lots of available credit. This signals to lenders that you have money to burn and an ability to make regular payments, so lenders become very eager to offer you additional lines of credit.
Lenders love to offer lines of credit because after introductory periods because most people are generally paying 15-30% APR on each line of credit. APR stands for Annual Percentage Rate, and this figure includes the interest that lenders collect from a given line of credit or account. APR is calculated by first combining the U.S. Prime Rate with the margin taken by the bank or lender. As of this writing, the U.S. Prime Rate currently sits at 5.25%.
The Prime Rate is used in almost all cases by U.S. banks in helping to determine interest rates on short or medium-length loans. All of the lending bureaus in the United States (banks, credit unions, private lenders, etc.) use the Prime Rate as a pricing foundation. This rate is federally regulated and implemented as a way to force banks and lenders to remain competitive with each other. It also allows businesses and individuals to do easier, more efficient cost comparisons between different lending bureaus or institutions. To get to the APR figure, banks and lenders add their own interest charge to the U.S. Prime Rate.
The rate added on by lenders ranges based on credit score (or “credit worthiness”) but generally falls between 10-15% for most borrowers. The APR on most accounts is usually no less than 5-10% and can balloon to 30% or more for people with poor credit. This is a key reason why proper credit card utilization and responsible use is so important.
Once an APR is assigned to an account – let’s say 20% APR for the sake of simple math – the APR is divided by the number of days in the year (365) to get the Daily Periodic Rate. This figure, the DPR, is then multiplied by the days in the billing period. Billing periods are generally monthly, so this number will typically be 30 or 31. DPR is multiplied by days in the billing period – let’s again say 30 for the sake of simplicity – and then multiplied by the rate subject to interest. In this example, we will say that the amount subject to interest is $500 USD.
This end number is the Interest Charged every month. At an APR of 20%, the total interest on $500 over a 12-month period would be $55.81. The math can get extremely complicated, so if you are considering taking out a loan or want to work on improving your credit card utilization, there are tools such as online APR calculators to help you understand exactly how much interest you’ll be paying over a given amount of time.
Also, there are different types of APR, such as APR on cash advances (which tends to be higher than the standard rate) and variable APR. It’s important to understand the difference between fixed and variable APR, as the differences can really spike the amount of interest you will ultimately have to pay. In short, credit card utilization is critical because poor utilization can leave you in a terrible financial trap, unable to make minimum monthly payments or get loans for emergency situations.
It’s vital that you learn and incorporate solid credit card utilization strategies so that you can ultimately live happier, better, and with more freedom and flexibility.
How to Maximize Credit Card Utilization
To make the most of credit card utilization, you’ll want to pay off the entirety of your purchase or purchases during introductory or promotional periods of low APR. Many credit card companies offer cards with promotions such as “0.0% APR for 12 months.” The way to take advantage of this opportunity is to pay off your credit purchase in full before the APR spikes to 15% or more.
Once you understand how credit card promotional rates work, you can set up a personal strategy for maximizing credit card utilization by paying off purchases in full during low or zero APR periods.
Additional Credit Card Utilization Tips
The number one tip for better credit card utilization, which is easy to understand but hard to implement, is to save your credit card space for true emergencies such as automotive or medical bills. We as consumers are encouraged to spend everywhere, and the invention of credit and debit cards sometimes distorts the perception of spending.
Restricting yourself to cash usage is a very effective tip for better credit card utilization, but this is easier said than done. Almost all credit and money management experts will recommend that you pay more than the minimum amount on your credit cards every month. This is rock-solid advice, but usually, by the time spenders heed this advice, they are in credit card trouble.
A better tip to limit total credit card spending is to get the utilization rate below 30-40% as soon as possible. This strategy will no doubt involve paying more than the monthly minimum payment, in most cases. Requesting a credit line increase is a bit of nuclear option and a potential trap, but one that some spenders may want to consider. A credit line increase will increase your available credit, lowering your utilization rate in the process.
However, the trick for most people is to let the available credit sit there untouched. This is often where credit card companies trap novice spenders, offering token amounts of credit in exchange for fees or to inspire additional card usage. Additionally, requesting a credit line increase may in some cases require a hard pull against your credit score. A hard pull lowers your total credit score and can stay on the account for 6-12 months or longer before dropping off.
A hard pull is not the same thing as a soft pull, and consumers would be wise to educate themselves on the difference between the two.
Better Credit Card Utilization for a Better Financial Profile
Credit cards are not something that you should be afraid of, but nor are they a free pass to irresponsible spending. Credit cards are best used as a selective tool to strategically increase credit score and occasionally to make smart investment purchases.
By improving credit card utilization and managing money better, you can set yourself for longer-term financial health while ensuring that you have a reserve available for true financial emergencies.