4 MinsJuly 19, 2021
Rakesh Mehra has two credit cards. He regularly swipes them until he exhausts their credit limits but always clears the bills on time. Recently, Rakesh applied for a home loan. His application took a long time to process. He had to go in for multiple meetings with the bank manager to convince them about his ability to afford the loan. Why? Because his credit utilisation rate was flagged in the credit report. He was using almost 100% of the credit available to him on all his cards. Rakesh never realised that swiping a card would land him in a soup.
To ensure you don’t make a mistake like Rakesh and struggle with your credit report, here’s what you need to know about credit utilisation and how it impacts your credit score:
What is a credit utilisation rate?
A credit utilisation rate or ratio is the total amount of credit currently being used by you, divided by the amount of credit available. Simply put, it is how much you now owe, divided by your credit limit. It is usually expressed as a percentage. For example, Rakesh had a credit limit of Rs 1,00,000 on both his credit cards put together. Yet, every month, he was swiping his card for almost Rs. 95,000. His credit utilisation ratio, therefore, was 95%.
Why is 95% a problem?
Imagine you are the manager of the bank where Rakesh has applied for a loan. Suppose Rakesh’s home loan EMI (equated monthly instalment) is Rs 50,000 a month, and Rakesh’s salary is Rs 1,50,000 a month. If Rakesh spends Rs 95,000 on his credit cards every month, it leaves him with just Rs 55,000 a month for other expenses. Rakesh is a credit risk for the bank manager because he is using the entire credit available to him. Therefore, the bank assumes that Rakesh will find it difficult to pay the EMIs.
What is a reasonable credit utilisation rate?
Credit experts recommend that you keep your total credit utilisation rate under 30%. Usually, a low credit utilisation ratio indicates that you are doing a good job of managing your finances and that you are a fiscally responsible individual who is not likely to go on a spending binge.
How does credit utilisation impact your credit score?
There are multiple ways of calculating credit scores and your credit card utilisation rate is one of the parameters that is taken into account while calculating the credit score. Typically, cardholders with low credit utilisation rates have better credit scores than those who have higher rates.
[Also Read: 7 factors that pull down your credit score]
How can Rakesh overcome this challenge?
There are quite a few options for Rakesh to improve his credit utilisation rate.
- The first and most obvious solution is to cut down on his expenses on his card. He should only swipe it for essentials like utilities, phone bills and fuel payments.
- He can apply for another credit card and spread his expenses over three cards. Even though his credit card utilisation rate will be over 30%, it will be a lot lower than 95%. He should take care not to increase his expenditure just because he has one more credit card.
- He can ask his current credit card companies to increase his credit limit. This will lower his credit card utilisation rate automatically. But, again, Rakesh should ensure that his expenses on credit cards don't rise.
- If he can’t reduce his credit card expenditure, he should pay off his credit cards dues twice a month. This will bring down his monthly credit utilisation ratio.
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