Why is Credit Utilization Ratio Important?

Shyam and Ganesh are two good buddies working in a manufacturing company. Both had applied for credit cards and were offered varied credit limits. While Shyam was spending at a barrage on the credit card he chose, Ganesh shopped with discipline yet fulfilled his needs via the plastic instrument.

Even though both paid dues on time, Shyam could not get the limit raised even after a year of spotless credit card payment. In contrast, it was a smooth sail for Ganesh who got the limit hiked as soon as he requested for the same.

The tale of these two friends brings to fore the importance of credit utilization ratio, a concept that most shoppers don’t practice and end up limiting their joy. Let’s spare some time with us to gauge the importance of credit utilization ratio of credit cards.

What is Credit Utilization Ratio?

The ratio represents the extent to which the credit limit is utilized by a shopper. The ratio is arrived at by adding the spends made on different credit cards and then dividing the resultant sum by the number of cards. The spends made on the card in a billing cycle would reduce from the credit limit sanctioned. Paying the bill would, however, restore the credit limit to the proportion of the payment made.

How Much Credit Card Limit Should You Utilize?

You should utilize the credit card limit carefully by spending on the actual needs and not get distracted by the shopping behaviour displayed by your peers. However, you must not be too less on utilizing as that won’t build your credit history in the desired way. Ideally, the utilization ratio must be within 30% of the credit card limit.

Benefits of Optimal Credit Utilization Ratio

An optimal credit utilization ratio can make you eligible for the following benefits.

Boosts Your Credit Record – An optimal utilization would help maintain a good credit score and credit history. A good score is anything above 700, with 750 and beyond can be deemed as excellent. The credit history carves an impression of the borrower in you. It will show the outstanding left, the payment made, different payment dates, the enquiry made by the lenders with respect to credit applications, etc.

Seamless Approval to Credit Applications – This benefit is rather a by-product of the earlier benefit. A good credit record maintained by virtue of optimal utilization can lead to approval of loans or credit cards without any fuss.

Credit Card Upgrade – It can also help you reap rewards in the form of a credit card upgrade, which means a hike in the credit limit or the offering of any other card replete with features missed in the existing card.

Makes Bill Payment Easy – If you utilize the limits carefully by spending on the exact needs, the bill that comes is easy to pay in full, thereby eliminating the scope for any interest and taxes to be levied. Paying the minimum due, accounting for about 5% of the total outstanding, or above the same but below the total due incurs interest at 2.50%-3.50% per month. If you keep paying like that, the interest will mount at 30%-45% annually. This could raise the total outstanding exponentially over time and push you into a possible debt trap to deal with.

How to Ensure Optimal Credit Utilization Ratio?

Ensuring an optimal credit utilization ratio can be an outright possibility by adhering to the following tips.

Assess Your Shopping Needs Carefully – One must figure out the needs that can be best met through credit card shopping. If you are with household responsibilities, your priorities would most probably be the shopping of groceries, accessories, etc. Similarly, one can feel for movies, travel and other needs. So, you should first choose the credit card that fulfills your needs the best and spend accordingly to maintain an optimal ratio.

Spend According to Your Income – Your income also plays a great role in deciding the quantum of spending that you can afford to do. Spending based on income ensures the bill is under control. You can thus spend around 20%-25% of your net monthly income to maintain the desired utilization ratio. However, you can do well to spend below that if you have any loan EMI running.

Say No to Impulsive Buying Behaviour – Living the grand lifestyle of others can be a pleasant experience but not when it adds to the debt burden. Impulsive shopping can be a reality with credit cards as they can enable purchase online as well as offline. Those getting caught into this shopping routine don’t only raise the credit card bill excessively high but also the credit utilization ratio, causing fears of a possible default. So, one must not get influenced by such shopping behaviour, instead, be aware of the needs, earnings and the repayment potential before spending on the card.