Credit Utilisation Ratio

The credit utilisation ratio (also known as credit utilisation or credit usage) is a crucial metric that compares the amount of credit you are currently using to your total available credit. It’s a key factor in determining your credit score, influencing how lenders perceive your creditworthiness. This ratio is typically expressed as a percentage, providing a clear snapshot of how much of your available credit you are currently relying on. 

How is the Credit Utilisation Ratio Calculated?

The credit utilisation ratio is calculated using the following formula:

 

Let’s break down each component of this formula:

Total Credit Used

Your “Total Credit Used” isn’t just about how many credit cards you have; it’s the aggregate of the outstanding balances on all your revolving credit accounts. Revolving credit differs from installment loans (like car loans or mortgages) where you borrow a fixed amount and repay it over a set period with scheduled payments. With revolving credit, your available credit replenishes as you make payments, and you can continue to borrow up to your credit limit.

Here’s a breakdown of what contributes to your total credit used:

It’s important to note that while installment loans are debts you owe, the balances on these accounts don’t directly factor into your credit utilisation ratio because they have a fixed repayment schedule and don’t represent continuously available credit in the same way as revolving accounts.

Total Available Credit

Your “Total Available Credit” represents the total borrowing power that lenders have extended to you through your revolving credit accounts. It’s the sum of the maximum credit limits assigned to each of your credit cards and lines of credit.

For example:

This total available credit is the denominator in the credit utilisation ratio formula. It signifies the total amount of credit that has been made accessible to you by lenders.

The Ratio in Action

Once you have calculated your total credit used and your total available credit, you can determine your credit utilisation ratio. This percentage provides lenders with a quick and easily understandable measure of how much of your available credit you are currently using.

For instance, if your total credit used is $4,500 and your total available credit is $15,000, your credit utilisation ratio would be:

This 30% figure indicates that you are currently using 30% of the total revolving credit that has been extended to you. Lenders generally view a lower credit utilisation ratio as a sign of responsible credit management.

The Significance of Credit Utilisation:

Lenders in Australia, like anywhere else, rely on credit scores to quickly and efficiently assess the risk associated with lending money. The credit utilisation ratio is a strong indicator of future repayment behaviour because it provides a real-time snapshot of how a borrower is currently managing their available credit.

  • Low Utilisation = Responsible Management: A low credit utilisation ratio indicates to lenders that you are managing your credit responsibly and are not overly reliant on borrowed funds. This suggests you are likely to:
    • Live within your means: You’re not maxing out your credit limits, implying you aren’t overly dependent on credit to cover your expenses.
    • Manage debt effectively: You’re keeping your balances low relative to your limits, suggesting you’re likely making regular and sufficient repayments.
    • Be prepared for financial hiccups: Having a significant amount of available credit suggests you have a buffer to handle unexpected costs without immediately needing to borrow more.

Lenders view borrowers with low credit utilisation as lower risk because their current behaviour aligns with sound financial management, making them more likely to repay future debts as agreed.

  • High Utilisation = Potential Financial Strain: Conversely, a high credit utilisation ratio can raise concerns for lenders:
    • Over-reliance on credit: Using a large portion of your available credit might suggest you are depending on borrowed funds to meet your ongoing expenses, indicating potential financial instability.
    • Higher risk of overextension: Maxing out or coming close to your credit limits can signal that you are at a higher risk of becoming overextended and struggling to make repayments if your financial circumstances change.
    • Limited financial flexibility: Having little available credit suggests you might not have a sufficient buffer to handle unexpected costs, potentially leading to missed payments or further borrowing.

Lenders see borrowers with high credit utilisation as higher risk because their current behaviour suggests a greater likelihood of encountering repayment difficulties. This can lead to lower credit scores and less favourable loan terms.

Deciphering the Utilisation Ranges

  • Excellent (Ideally below 30%): The Green Light: This range signals exemplary credit management. Lenders see you as a very low-risk borrower who handles credit responsibly. You’re likely to qualify for the best interest rates and loan terms on products like home loans, car finance, and personal loans.

  • Good (30% – 50%): Proceed with Caution (from a score perspective): While generally acceptable, this range suggests you’re using a moderate amount of your available credit. Lenders might see you as slightly more risky than someone with lower utilisation. Bringing this down can lead to a better credit score and potentially improved loan offers.

  • Fair (50% – 70%): Approaching the Yellow Light: This level of utilisation indicates a more significant reliance on credit. Lenders may become more concerned about your ability to handle additional debt. Your credit score is likely being negatively impacted, and you may face higher interest rates or lower approval odds for new credit.

  • Poor (Above 70%): The Red Light: High credit utilisation in this range is a major red flag for lenders. It strongly suggests financial strain and a higher risk of default. Your credit score will likely be significantly lower, and you may struggle to get approved for new credit or may only be offered very unfavourable terms, if at all. Bringing your utilisation down should be a top financial priority for improving your creditworthiness in the Australian financial landscape.

In essence, your credit utilisation ratio is a dynamic indicator of your current credit health. By keeping it low, you demonstrate responsible financial behaviour and build trust with lenders, ultimately leading to better access to credit and more favourable financial opportunities across various borrowing needs in Australia.

Think of your credit report as a portfolio of your borrowing behaviour. Lenders want to see not just the overall picture (your total credit used compared to total available credit) but also how you manage each individual credit facility within that portfolio.

  • Overall Credit Utilisation: The Big Picture: This gives lenders a general sense of your reliance on credit. A low overall ratio suggests you’re managing your total borrowing responsibly. It paints a picture of someone who has access to credit but isn’t heavily dependent on it across all their accounts. A high overall ratio, even if no single card is maxed out, can suggest you’re carrying a significant debt burden relative to your available credit, which can be a concern.

  • Individual Credit Utilisation: Spotting Potential Trouble: Looking at each credit account individually allows lenders to identify potential areas of concern that the overall ratio might mask. For example, if you have three credit cards with a $10,000 limit each (total available $30,000) and you’re carrying a $9,000 balance on one card while the other two have zero balances (total used $9,000), your overall utilisation is a healthy 30%. However, the fact that you’ve maxed out one card signals a higher risk on that specific account. It could indicate a tendency to overspend on one line of credit or a potential inability to manage that particular debt effectively. Lenders might be wary of this behaviour, even if your overall usage seems okay.

Credit scoring models also take this dual perspective into account. Maxing out a single credit card can have a disproportionately negative impact on your score, even if your overall utilisation is low, because it suggests a higher risk of financial distress on that particular account.

Strategies for Improving Your Credit Utilisation Ratio

Here’s a more in-depth look at the strategies for improving your credit utilisation ratio:

  • Pay Down Balances:

    • Prioritise High-Interest Debt: If you’re carrying balances on multiple cards, focus on paying down those with the highest interest rates first to save money on interest charges while also lowering your utilisation.
    • Set a Budget: Create a budget to track your spending and identify areas where you can cut back to free up funds for debt repayment.
    • Make Extra Payments: Even small extra payments above the minimum can significantly reduce your balance over time and improve your utilisation faster.
    • Consider a Debt Management Plan: If you’re struggling with multiple debts, a debt management plan through a reputable credit counselling agency might help you consolidate payments and potentially lower interest rates, making it easier to pay down balances.

  • Increase Your Credit Limits (Responsibly): 

    • Only if You Trust Yourself: Increasing your credit limit should only be considered if you are confident you won’t be tempted to spend more. An increased limit provides more breathing room in your utilisation ratio without requiring you to spend less.
    • Consider Account Age: Lenders are generally more likely to approve credit limit increases on older accounts with a good payment history.
    • Avoid Frequent Requests: Applying for too many credit limit increases in a short period can sometimes raise concerns for lenders.

  • Make Multiple Payments Throughout the Month: 

    • Understand Your Reporting Cycle: Credit card companies typically report your balance to credit bureaus around your statement closing date. By making payments before this date, you can ensure a lower balance is reported.
    • Automate Payments: Setting up automatic payments for a portion of your balance a few times a month can help keep your reported utilisation low without requiring constant manual effort.

  • Avoid Maxing Out Credit Cards: 

    • Aim for the “Excellent” Zone Individually: Just like your overall utilisation, try to keep the balance on each individual credit card well below 30% of its limit.
    • Be Mindful of Small Limits: Even a small balance on a card with a very low credit limit can result in a high utilisation ratio for that specific card.

  • Consider Balance Transfers (Carefully): 

    • Focus on Interest Savings: Balance transfers are most beneficial when you can secure a 0% introductory APR, allowing you to pay down the balance without accruing interest for a period.
    • Factor in Transfer Fees: Carefully calculate whether the transfer fees outweigh the potential interest savings.
    • Don’t Close Old Accounts Immediately: While transferring a balance off a high-utilisation card can help, closing that account immediately might reduce your overall available credit, potentially negating some of the benefit to your overall utilisation. Keep the account open (if there are no fees) and use it sparingly to maintain the available credit.

Factors That Don’t Affect Credit Utilisation: Staying Focused

It’s important to clarify what doesn’t factor into your credit utilisation ratio to avoid confusion:

  • Installment Loans: The outstanding balances on loans with a fixed payment schedule, such as mortgages, car loans, and personal loans with a set term and payment amount, are not typically included in the credit utilisation ratio calculation. This is because these loans are not revolving credit; you borrow a fixed sum and pay it back over time, and the available credit doesn’t replenish as you make payments. While these loans do impact your overall debt burden and are considered in your credit report, they don’t directly affect your credit utilisation ratio.

  • Debit Card Usage: Spending money using your debit card does not impact your credit utilisation. Debit cards draw funds directly from your bank account and do not involve borrowing credit. Therefore, your debit card transactions have no bearing on how much of your available credit you are using.

Conclusion

The credit utilisation ratio stands as a critical factor in determining your credit score, significantly influencing how lenders perceive your creditworthiness, even when considering options like bad credit car loans where interest rates are typically higher due to the increased risk. Maintaining a low credit utilisation is paramount for achieving and sustaining a healthy credit score, which in turn opens doors to better access to credit with more favourable terms, such as lower interest rates on loans and credit cards.

By understanding how this ratio is calculated and its impact on your credit, you can take actionable steps to manage and improve your credit utilisation. This includes diligently paying down balances on your revolving credit accounts, strategically considering credit limit increases, making multiple payments throughout the month, avoiding maxing out your credit cards, and carefully evaluating balance transfer options. By proactively managing your credit utilisation, you empower yourself to build a strong credit profile and achieve your financial goals.