What is credit utilisation? Here's how it affects your credit score

Credit utilisation ratio is one of the most important factors that affect your credit score directly. Your credit score reflects your creditworthiness and credit history.

Now, let’s understand what the credit utilisation ratio is, how it is calculated, and why it is crucial for credit score.

What is the credit utilisation ratio?

A credit utilisation ratio is calculated based on the quantum of the available credit that you have used. It plays a crucial role in figuring out your credit score, which is a numerical representation of your creditworthiness. For example, if you have a credit card with a limit of ₹1 lakh and you are using ₹30,000 of that limit, your credit utilisation ratio would be 30%.

Credit utilisation ratio helps lenders determine the risk of extending loans or credit products to you considering how responsible you have been in managing your credit instruments.

Credit ratio calculation: How to do it?

To determine your credit utilisation ratio, use the formula — Total Outstanding Balance / Total Credit Limit X 100.

Let’s understand the credit ratio calculation using an example. Let’s say you have two credit cards. The total credit limit on both cards is ₹1 lakh. On one card, you have an outstanding balance of ₹50,000, while the other card has a balance of ₹0. To calculate your credit utilisation ratio, add up the outstanding balances on both cards (₹50,000 + ₹0) and divide this sum by the total credit limit (₹1 lakh). Then multiply the result by 100 to get the percentage, which is 50,000 / 1,00,000 X 100. Based on this, your credit utilisation ratio will be 50%. The credit agencies also take into account the credit utilisation ratio for individual instruments, like credit cards, as well as overall ratio across all products to finalise the credit score.

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Why is credit utilisation ratio important?

The credit utilisation ratio is a significant factor in credit score calculation. Here’s why:

• Reflects if you are financially responsible: Generally speaking, a lower credit utilisation ratio means that you are handling your credit in a responsible manner. It implies that you have good money management skills and are not unduly dependent on credit.


• Impacts your credit rating: Your credit utilisation ratio is taken into account by credit scoring models, in order to determine your credit score. While a higher ratio could have a detrimental effect on your credit score, a lower ratio can help you score higher.


• Impacts lender decisions: When determining the risk of extending a loan or credit to you, lenders look at your credit score, which includes your credit usage ratio. If your ratio is low, you might be able to get better loan conditions and interest rates because you are a more appealing borrower.

Credit utilisation ratio: How to manage it

Maintaining a healthy credit utilisation ratio can positively impact your credit score. Here are a few ways in which you can manage it effectively:

• Keep balances low: Aim to use less than 30% of your available credit limit. This threshold is often recommended by credit experts as a good practice for maintaining a healthy credit ratio.


• Pay off balances regularly and on time: Make it a habit to pay off your credit card balances in full each month before the deadline. This practice helps in reducing your credit utilisation ratio and ensures that your credit ratio calculation reflects positively. Timely payments also help you avoid interest charges and maintain a healthy credit score


• Increase your credit limit: If you have a good credit history, consider requesting a higher credit limit from your lender. A higher limit can lower your credit utilisation ratio, provided your spending remains the same.


• Monitor your credit reports: Regularly review your credit reports to ensure your credit utilisation ratio is accurate. Any kind of error can negatively impact your ratio and your credit score.


• Avoid opening multiple new accounts: While opening new credit accounts can enhance your total credit limit, it can also cause a temporary decline in your credit score due to hard inquiries. These inquiries impact the credit score calculation and can lower your overall score. Be strategic and considerate when applying for new credit to manage its effect on your overall credit health.


• Pay off a large transaction before the bill generation date: If you make a large transaction using your credit card just to avail an offer, you can consider paying it off even before the bill is generated.

ALSO READ: What Affects Your Credit Score & How To Build a Healthy Credit Score

Understanding and managing your credit utilisation ratio is crucial for maintaining a healthy credit score. By keeping your credit usage low relative to your available credit limit, you can show responsible credit management and potentially improve your credit score. Use tools available on platforms like Moneycontrol to monitor your credit score and get insights into how your credit utilisation ratio affects your financial health.