As many of you probably know, credit scores are a vital piece of any FIRE journey. A good credit score can make it easier to do a lot of things like getting favorable interest rates, getting access to loans with the best terms, and unlocking a bunch of other benefits and savings. On the other hand, a bad credit score can make even the simplest financial tasks that much more difficult.
This is why being able to increase your credit score is so important. Unfortunately, some people have credit scores that are pretty much stuck in place. If that’s you: don’t worry! This doesn’t mean that you’re doomed to fall victim to a subpar credit score forever.
There are actually a number of ways that you can increase your credit score. This is because there are a bunch of different factors that go into determining what credit score you end up with. Specifically, your Payment History accounts for a whopping 35% of your credit score. Likewise, Credit Utilization also accounts for a huge 30% of your credit score. On top of that, Total Accounts and Credit Inquiries make up 10% each, and Age of Account makes up the remaining 15%.
So based on that breakdown, it's clear that in order to make the biggest impact on your credit score, you have to attack the areas that contribute the most to determining that credit score: payment history and credit utilization.
In this post, I’m going to focus solely on credit utilization because it seems to be the area that causes the most confusion for people.
So keep reading and I’ll walk you through what exactly credit utilization means, why it's important, and how you can control and use credit utilization to your benefit, so you can raise your credit score!
What is Credit Utilization?
Your Credit Utilization Rate (or Credit Utilization Ratio) is the amount of revolving credit that you are currently using divided by the total amount of revolving credit you have available.
Simply put, it’s the amount you OWE divided by your CREDIT LIMIT.
So, if you spend $500/month when your credit card limit is $1,000, then your Credit Utilization Rate would be 50% because 500 ÷ 1,000 = .50.
Why is Credit Utilization Important?
Because credit utilization accounts for 30% of your credit score, or 250 of a total possible 800 points, it is obviously something that is really important to determining your score. So focusing on credit utilization is one way to increase your credit score.
The thing about credit utilization though, is that it works in a way that is kind of counter to what we’ve all been taught about credit cards. Most people think that as long as they pay off their credit card bill in full by the due date every month, they are good to go.
But this isn’t exactly how the credit agencies see it. They don’t read this as you having paid off your credit card. Really, what’s being reported to the credit agencies when you do this is that you have utilized a portion of your credit.
So let’s say you spend $1,000 and your credit limit is $2,000. Let’s also say that you’re really responsible with your credit and you pay off your entire $1,000 credit card debt at the end of the month on the due date. You may be surprised to learn this, but by paying off your entire $1,000 bill, your Credit Utilization Ratio (CUR) would still be 50%.
And to be clear, a 50% CUR is NOT GOOD!
An excellent CUR would be somewhere between 0 and 9%. A good CUR would be from 10-29%. A fair CUR is from 30-49%. A poor CUR is from 50-74%. And a terrible CUR is anything over 75%.
So here’s the thing: you need to aim for a CUR that’s between 0% and 29% (excellent or good) in order to have a significant positive impact on your credit score.
Before you rush out and cancel all your cards though, remember that there are other factors that influence your credit score like your credit history and account activity. So while cancelling your cards might sound like the perfect solution, this will actually look terrible to the credit agencies.
Ok, so what about just not using your cards? Well, doing this essentially means that you are rendering your credit card inactive, and inactivity won’t have any kind of impact on your credit score at all, positive or negative. So neither canceling nor not using your credit card will be helpful in raising your credit score.
How Can You Improve Your Credit Utilization Ratio?
At this point you’re probably sitting there wondering what it is that you CAN do to reduce your CUR.
The answer is actually pretty simple: make sure you pay your credit card bill in full, BEFORE the STATEMENT CLOSING DATE (not just before the due date). The key here is to understand that the statement due date is NOT the same as your statement closing date.
Your due date is the date that you have to pay your bill by before the amount starts to accrue interest. Your statement closing date, on the other hand, refers to the date most credit card companies REPORT your utilization to the credit bureaus.
Let's look at an example. If your credit card closing date is on the 25th and your due date is on the 30th, even if you pay your bill in full on the 28th, it’s reported to the credit bureau as unpaid, because at the time the company sent its report to the credit bureau, the balance wasn’t actually paid off yet. Now, if you pay off the card before the statement closing date, say the 23rd, the credit utilization ratio that the credit card company reports becomes 0%. And 0% is the best rate you can get!
That said, I totally get that not everyone is in a financial position to pay off their credit card in full every month. If this is the case, you can still improve your credit score by:
Paying off as much as you can; and
Making sure that you pay whatever you do before the statement closing date
Do this and you could see your score shoot up within 30 days!
So just remember, if you want to drastically improve your credit score by focusing on your Credit Utilization Ratio, don’t wait until the due date to pay off your credit card bill. Make sure you pay your entire credit card bill (or as much as you can) BEFORE your STATEMENT CLOSING DATE! It’s that easy!