Understanding credit cards and how they work is what this post will pertain to. Many people in the US don't understand exactly how credit cards work, and how they can help or hurt you. With this post, we will point out a few basic details regarding utilization rates on credit cards.
What are Utilization Rates?
Utilization Rates on credit cards are essentially the percent of the credit card that is used. It's a measure of what your balance is, compared to the overall credit limit that the specific card has. Utilization rates play a key role in determining your credit score, your lending ability, and a variety of other factors. Utilization rates are based solely on credit cards or lines of credit, also known as your revolving credit.
It's called "Revolving Credit" because it does not have a pre-determined end date. The amount you owe carries over (revolves) from month to month. With installment loans, such as mortgages, personal loans, car loans, etc, they have a pre-determined end date, meaning you take the loan out for a specific period of time. Your total utilization rate is the measure of all of your revolving balances compared to the overall credit limit that you have.
Utilization Rate Example: $3,000 balance / $5,000 = 60% Utilization Rate
What is a good credit utilization rate?
Ideally, you'd like to be able to pay off your credit cards to a zero balance each month, therefore you do not carry balances over that have the ability to continue to accrue interest. Obviously, in life, it's difficult due to unexpected expenses and the cost of living continuing to increase so quickly. With that said, according to FICO scores and what they would like to see, it is recommended to keep your total credit utilization rate below 30%. A low credit utilization is a good indicator that you're doing a good job of managing your spending and expenses, and you're not reliant on the use of credit cards each month.
When you have very high utilization rates on credit cards, or balances towards the limits (when credit cards essentially become maxed out), that is when it can work very harshly against your credit score. When cards are maxed out, the way it is seen in the finance world, is that someone unfortunately is too reliant on the use of credit cards. At that point, most people will see their credit scores start to decrease because they want to eliminate your borrowing ability, increase the interest rates on the credit cards, and hope you can only make minimum payments so they can make a huge profit off of you. When you're only able to make minimum payments, or a little more than minimums, the vast majority of your payment goes towards interest, also known as profit. The balance of the account only has a small amount of the payment go towards it. That's why it becomes extremely difficult for individuals to pay off the credit card debt that they have.
*IMPORTANT NOTE* - When credit cards become at least 50% used or more, so if you have a 50% utilization rate or higher, that is when a creditor has the right to raise the interest rate to the max interest rate they charge. It does not mean that a creditor will do so, but they have the ability to. That is when individuals are seen more of a risk, so they raise the interest rates to capitalize on as much profit as possible.
Another key factor is the amount of credit cards that you have with high utilization rates. If an individual has 1 or 2 credit cards, then it won't hurt the credit nearly as much. When an individual has more than 5 credit cards and all 5 are maxed out, or have really high utilization rates, then it starts to work more negatively against your credit score.