Credit Utilization Ratio | The Basics

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Our last blog post was a brief introduction to debt and focused on the debt-to-income ratio. We used Lebo's financial situation as an illustrative example. In this blog post we'll analyse and interpret his credit-utilisation ratio, but before we do so let's first understand what a credit utilisation ratio (CUR) is.

Credit Utilisation Ratio

A credit utilisation ratio shows how much (the percentage) of their available credit a debtor has used. 

It adds up your debt (balances on credit cards, store cards, etc) and divides it by the total credit limit. Debt is the money you owe. Your total credit limit is the total amount of credit made available to you by your creditors. For example, you have an account with ABC Clothing. The total available credit they've made available to you is R10 000. You buy clothes worth R2 350 on account. Assuming you don't have any other debt or accounts, your total debt is R2 350 and your total credit limit is R10 000.

The debt the credit utilisation ratio takes into consideration is credit such as store accounts, credit cards, overdrafts, revolving loans, etc. Debt excluded from the credit utilisation ratio is home loans and vehicle finance.

The credit utilisation ratio formula is as follows:

Let's continue with the illustrative example of Lebo's personal finances. Lebo has the following debt balances and credit limits:

As can be seen above, Lebo's total debt balance is R8 750 and his total credit limit is R57 000. We're going to substitute these amounts into the credit utilisation ratio formula to calculate Lebo's credit utilisation ratio:

CUR % 

= (R8 750/R57 000) * 100

= 0.154 * 100

= 15.4%

Lebo's credit utilisation ratio is 15.4%. This means that he has used 15.4% of the credit made available to him by his creditors. What does this mean? Is this good or bad? 

Recommended credit utilisation ratio

It is usually recommended that individuals have have a credit utilisation ratio less than 30%.(1) This is because it lets lenders and creditor know that you are a responsible borrower. In addition, it shows that you do not use up all the credit made available to you (you have credit available). 

Lebo's credit utilisation ratio is 15.4%. This is within the recommended credit utilisation ratio of 30% or less. Furthermore, this means that Lebo still has credit of 84.6% (100% - 15.4%) available to him. This lets lenders know he is a responsible credit user. 

From the above analysis, it can be said that Lebo's credit utilisation ratio is good. Lenders may view him as a borrower who does not overspend and manages his credit well. (2) 

Benefits of having a low Credit Utilisation Ratio

There are numerous benefits to having a low credit utilisation ratio, namely (3):

• Possibly improved credit score
• Borrower has more credit available
• Ability to access additional credit if needed

Possibly improved credit score

If an individual has a low credit utilisation ratio, it may help them improve their credit score. This is because having a low credit utilisation ratio accounts for as much as 30% of a person's credit score. (4) By keeping one's credit score within the recommended limit of <30%, an individual can improve their credit score. 

All other things being equal, Lebo's credit utilisation ratio of 15.4% (which is less than 30%) positively contributes towards his credit score. 

Borrower has more credit available

Having more credit available can help the borrower in situations where they may need to make use of credit (in the event that one does not have emergency savings). However, it is usually recommended that consumers build an emergency fund so they do not have to rely on debt when faced with an emergency. (5) 

Lebo has used R8 750 of his credit limit (credit made available to him by creditors). This means that the credit he has available is R48 250 (R57 000 - R8 750). Should Lebo need to use the credit he has available—in lieu of emergency funds he may not have available—he can do so.

Ability to access additional credit if needed

If a consumer has a low credit utilisation ratio this means they are using less of their credit limit. Creditors may see this as the consumer managing their credit well by not using too much of it. The consumer thus looks responsible in the creditors' eyes. This behaviour of not using too much of the credit made available to the borrower can help the borrower improve their credit score. An improved credit score can help a consumer obtain additional credit if needed. This can be helpful with securing home loans, vehicle finance, etc.

Lebo has used only 15.4% of his credit limit. This is almost half the recommended credit utilisation ratio of 30%. His creditors may view him as managing his credit well because he does not overspend. Therefore, Lebo may be viewed as responsible in his creditors' eyes. This can result in Lebo's credit score improving. An improved credit score can help Lebo secure additional credit if needed. This an be helpful should Lebo want to obtain a home loan or vehicle finance in the future.

Please note that the credit utilisation ratio is not the only thing a creditor looks at when deciding to provide finance to a borrower.

How to improve one's credit utilisation ratio

Now that the benefits of having a low credit utilisation ratio have been discussed, let's look how one can improve their credit utilisation ratio.

Consumers can do the following to improve their credit utilisation ratio (6):

• Opening a new credit account
• Applying for a credit limit increase
• Paying the balance of a credit account in full every month
• Paying off the balance on an account and keeping the account open

Opening a new credit account

Opening a new credit account (and not using the credit on it) can help lower the borrower's credit utilisation ratio. This is due to the fact that the opening of a new credit account will lead to an increased credit limit while the total debt used has remained the same (remember the CUR formula?). However, the borrower should take care to ensure they do not open too many credit accounts in a short period of time because this can negatively affect their credit score in the short term. Furthermore, the borrower must exercise care when using the new credit account.

Applying for a credit limit increase

The borrower can apply for a credit limit increase on one of their credit accounts (for example, a credit card). This can help lower the borrower's credit utilisation ratio if the borrower does not make use of the additional credit. This is because the credit limit (the denominator in the CUR formula) has increased, while the debt (the numerator in the CUR formula) has remained the same. 

Paying off the balance on an account and keeping the account

By paying off the balance on an account and keeping the account, the borrower has kept that account balance at nil while the credit limit remains what it was. This keeps the credit utilisation of that account to nil, which falls within the recommended less than 30% credit utilisation ratio.

These tips, alone or in combination, can help a consumer lower their credit utilisation ratio. Moreover, they can help the consumer improve their credit score.

Closing

The credit utilisation ratio (CUR) is an important ratio that helps consumers know how much of their total credit limit they have used. The formula of the CUR was given, as well as the types of debt included and excluded therefrom. In addition, we looked at what the recommended credit utilisation ratio is and the benefits of having a low CUR. Lastly, various tips were given on how to lower one's credit utilisation ratio.

Thank you for taking the time to read this blog post. I hope you enjoyed reading it as much as I did writing it.

Take care,

                                                            

List of sources consulted:

1. Fiano, L. 2019. Credit score myths that might be holding you back from improving your credit. [O]. Available: 

https://www.consumerfinance.gov/about-us/blog/credit-score-myths-might-be-holding-you-back-improving-your-credit/ Accessed 2021/01/23

 

2. What is a Credit Utilisation Rate? [Sa]. [O]. Available: 
https://www.experian.com/blogs/ask-experian/credit-education/score-basics/credit-utilization-rate/ Accessed 2021/01/23

3. What is a Credit Utilisation Rate? [Sa]. [O]. Available: 
https://www.experian.com/blogs/ask-experian/credit-education/score-basics/credit-utilization-rate/ Accessed 2021/01/23

4. What factors affect your credit score? 2020. [O]. Available: 
https://www.africanbank.co.za/en/home/blog-landing/credit-score-factors/Accessed 2021/01/23

5. The urgency of an emergency fund [Sa]. [O]. Available: 
https://www.life-force.co.za/the-urgency-of-an-emergency-fund/Accessed 2021/01/23

6. What is a Credit Utilisation Rate? [Sa]. [O]. Available: 
https://www.experian.com/blogs/ask-experian/credit-education/score-basics/credit-utilization-rate/ Accessed 2021/01/23

Disclaimer:

This blog post is for informational purposes only and does not constitute financial advice. 

The information presented herein is not a substitute for and should never be relied upon for professional financial advice.

Always talk to your financial advisor about the risks and benefits of any financial information shared. If you are looking for financial advice, kindly speak to somebody who is certified and registered with the Financial Sector Conduct Authority (FSCA).

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