Credit Utilization

What is Credit Utilization?

Credit utilization is a key concept in personal finance, especially for anyone looking to secure loans for real estate investments. Simply put, it's the amount of revolving credit you're currently using compared to the total amount of revolving credit available to you. Revolving credit typically refers to credit cards and lines of credit, where you can borrow, repay, and re-borrow funds up to a certain limit. It's expressed as a percentage.

Think of it like a gas tank. If your car has a 10-gallon tank (your total credit limit) and you've used 3 gallons (your current balance), your utilization is 30%. Lenders and credit scoring models, like FICO and VantageScore, pay close attention to this percentage because it indicates how reliant you are on borrowed money and how well you manage your existing credit. A lower credit utilization ratio generally suggests responsible credit management, while a high ratio can signal financial distress or over-reliance on credit, which can negatively impact your credit score.

Why Credit Utilization Matters for Real Estate Investors

For real estate investors, understanding and managing credit utilization is not just good financial practice; it's absolutely crucial. Your credit score is a major factor lenders consider when you apply for a mortgage or any other type of real estate financing. A strong credit score, heavily influenced by your credit utilization, can unlock better loan terms, lower interest rates, and higher loan amounts, saving you tens of thousands of dollars over the life of a loan.

Here's why it's so important:

• Loan Approval: Lenders use your credit score as a primary indicator of your creditworthiness. A high credit utilization ratio can make you appear risky, potentially leading to loan denials or requiring a larger down payment.
• Interest Rates: Even if approved, a higher utilization (and thus a lower credit score) will typically result in a higher interest rate on your mortgage. Over 15 or 30 years, a small difference in interest rates can translate into significant additional costs.
• Loan Terms: Beyond interest rates, your credit utilization can affect other loan terms, such as fees, points, and even the loan-to-value (LTV) ratio a lender is willing to offer. Better credit often means more favorable terms.
• Access to Capital: As an investor, you'll likely need to access capital repeatedly for new acquisitions, renovations, or unexpected expenses. Maintaining excellent credit utilization ensures you have consistent access to affordable financing.

How to Calculate Your Credit Utilization Ratio

Calculating your credit utilization ratio is straightforward. You'll need two pieces of information: your total current credit card balances and your total available credit limits across all your revolving accounts.

The Simple Formula

The formula is:

• (Total Credit Card Balances / Total Credit Limits) x 100 = Credit Utilization Ratio (%)

Let's look at a few examples:

Example 1: Single Credit Card

Imagine you have one credit card with a credit limit of $5,000. Your current balance on that card is $1,000.

• Current Balance: $1,000
• Credit Limit: $5,000

Calculation: ($1,000 / $5,000) x 100 = 20%

In this case, your credit utilization ratio is 20%. This is generally considered a good ratio.

Example 2: Multiple Credit Cards

Most people have multiple credit cards. When calculating your overall credit utilization, you need to sum up all your balances and all your limits.

Let's say you have three credit cards:

• Card A: Limit $5,000, Balance $1,000
• Card B: Limit $10,000, Balance $2,000
• Card C: Limit $2,000, Balance $500

First, calculate your total balances:

• Total Balances: $1,000 + $2,000 + $500 = $3,500

Next, calculate your total credit limits:

• Total Limits: $5,000 + $10,000 + $2,000 = $17,000

Calculation: ($3,500 / $17,000) x 100 = 20.59%

Your overall credit utilization ratio is approximately 20.59%. It's important to note that credit scoring models also look at the utilization on individual cards. So, even if your overall ratio is low, having one card maxed out could still negatively impact your score.

The "Ideal" Credit Utilization Ratio

While there's no magic number, most financial experts and credit scoring models suggest keeping your credit utilization ratio below 30%. This means if your total credit limit is $10,000, you should aim to keep your total balances below $3,000. However, the lower your utilization, the better. Many top-tier credit scores are achieved with utilization ratios below 10%.

Why is lower better?

• Demonstrates Responsibility: A low ratio shows lenders that you can manage your credit responsibly and are not over-reliant on borrowed funds.
• Indicates Financial Stability: It suggests you have enough income or savings to cover your expenses without needing to use a large portion of your available credit.
• Signals Lower Risk: Lenders view borrowers with low utilization as less likely to default on their payments, making them more attractive candidates for loans.

It's also worth noting that a 0% utilization ratio isn't always the absolute best. While it means you're not carrying a balance, some credit scoring models prefer to see some activity on your accounts to demonstrate active and responsible credit use. The sweet spot is typically low, but not zero, utilization.

Impact on Your Credit Score

Credit utilization is one of the most significant factors in calculating your credit score, typically accounting for about 30% of your FICO score. This makes it the second most important factor after payment history.

FICO and VantageScore Models

Both the FICO Score and VantageScore, the two most common credit scoring models, heavily weigh credit utilization. They assess not only your overall utilization across all accounts but also your utilization on individual credit cards.

How High Utilization Hurts Your Score

When your credit utilization ratio is high (e.g., above 30%, and especially above 50% or 70%), it sends a red flag to lenders. It suggests that you might be struggling financially, relying heavily on credit to make ends meet, or that you are a higher risk for defaulting on your debts. This perception of higher risk directly translates to a lower credit score.

A lower credit score can lead to:

• Higher interest rates on loans and credit cards.
• Difficulty qualifying for new credit or loans.
• Less favorable terms on mortgages, car loans, and other financing.

How Low Utilization Helps Your Score

Conversely, maintaining a low credit utilization ratio demonstrates that you are a responsible borrower who uses credit wisely. It shows that you have access to credit but don't need to rely on it heavily, which makes you a lower risk in the eyes of lenders. This responsible behavior is rewarded with a higher credit score.

Example 3: Score Impact Scenario

Let's consider an investor, Sarah, who has a total credit limit of $20,000 across all her credit cards.

• Scenario A: High Utilization
• Sarah's current balances total $15,000.
• Utilization: ($15,000 / $20,000) x 100 = 75%.
• Result: Sarah's credit score is likely in the low 600s, making it difficult to qualify for a good mortgage.

• Scenario B: Low Utilization
• Sarah pays down her balances to $2,000.
• Utilization: ($2,000 / $20,000) x 100 = 10%.
• Result: Sarah's credit score significantly improves, potentially reaching the high 700s or even 800s, opening doors to the best mortgage rates.

Strategies to Optimize Your Credit Utilization

Improving your credit utilization is one of the fastest ways to boost your credit score. Here are actionable strategies for real estate investors to optimize their ratios:

Step-by-Step Process for Improvement

1. 1. Monitor Your Credit Reports and Balances: Regularly check your credit reports from all three major bureaus (Equifax, Experian, TransUnion) to ensure accuracy and understand your current credit limits and balances. You can get free copies annually at AnnualCreditReport.com. Also, keep track of your monthly statements.
2. 2. Pay Down Balances: This is the most direct way to lower your utilization. Focus on paying down high-balance credit cards first. Even if you can't pay off everything, reducing your balances significantly will have a positive impact. Aim to pay your statement balance in full each month if possible.
3. 3. Make Multiple Payments Per Month: Credit card companies typically report your balance to credit bureaus once a month, usually around your statement closing date. If you make payments throughout the month, your reported balance will be lower, leading to a better utilization ratio. For example, if you spend $1,000 on a card with a $5,000 limit, pay $500 mid-month and the remaining $500 before the statement closes. This keeps your reported balance at $0, or very low.
4. 4. Request Credit Limit Increases: If you have a good payment history and your income has increased, you can ask your credit card issuer for a credit limit increase. This boosts your total available credit without increasing your debt, thereby lowering your utilization ratio. However, only do this if you trust yourself not to spend the newly available credit.
5. 5. Avoid Closing Old Accounts: While it might seem counterintuitive, closing old, unused credit card accounts can actually hurt your utilization. When you close an account, that credit limit is removed from your total available credit, which can cause your utilization ratio to jump if you carry balances on other cards. Keep old accounts open, even if you don't use them, as long as they don't have annual fees.
6. 6. Use Different Cards Strategically: If you have multiple cards, try to spread out your spending or use cards with higher limits for larger purchases. This prevents any single card from having a very high utilization ratio, even if your overall ratio is low.

Example 4: Strategic Balance Management

Consider an investor, Mark, with two credit cards:

• Card X: Limit $5,000, Balance $4,000 (80% utilization on this card)
• Card Y: Limit $10,000, Balance $1,000 (10% utilization on this card)

Mark's total balance is $5,000, and his total limit is $15,000. His overall utilization is ($5,000 / $15,000) x 100 = 33.33%. While this is slightly above the 30% guideline, the 80% utilization on Card X is a major red flag.

Mark's strategy:

• Focus on Card X: Mark prioritizes paying down Card X. He pays $3,000, reducing its balance to $1,000.
• New Utilization for Card X: ($1,000 / $5,000) x 100 = 20%.
• New Overall Utilization: Total balances are now $1,000 (Card X) + $1,000 (Card Y) = $2,000. Total limits remain $15,000. Overall utilization is ($2,000 / $15,000) x 100 = 13.33%.

By strategically paying down the card with the highest individual utilization, Mark significantly improved both his individual card utilization and his overall ratio, leading to a better credit score.

Credit Utilization and Mortgage Applications

When you apply for a mortgage, lenders conduct a thorough review of your financial health, and your credit utilization ratio is a critical component of that assessment. It directly impacts your credit score, which in turn affects your eligibility and the terms of your loan.

Lender's Perspective

Lenders want to see that you can handle debt responsibly. A low credit utilization ratio signals that you have plenty of available credit but aren't maxing it out. This suggests financial stability and a lower risk of default. Conversely, high utilization can make lenders nervous, as it might indicate that you are living paycheck to paycheck or are overextended.

They also look at your debt-to-income (DTI) ratio, which compares your monthly debt payments to your gross monthly income. While credit utilization isn't directly part of the DTI calculation, high credit card balances lead to higher minimum payments, which can push your DTI higher and make it harder to qualify for a mortgage.

Pre-Approval and Loan Terms

Before you even start seriously looking for properties, getting pre-approved for a mortgage is a crucial step. Your pre-approval amount and the estimated interest rate you receive are heavily dependent on your credit score, which, as we know, is significantly affected by your credit utilization. A higher score due to low utilization can lead to:

• Better Interest Rates: This is perhaps the most impactful benefit. Even a half-percent difference in your interest rate can save you tens of thousands of dollars over the life of a 30-year mortgage.
• Higher Loan Amounts: Lenders may be willing to lend you more money if they see you as a low-risk borrower, which can be critical for securing desirable investment properties.
• More Favorable Terms: Beyond interest rates, you might qualify for lower closing costs, fewer fees, or more flexible repayment options.

Example 5: Mortgage Impact

Let's illustrate the financial impact of credit utilization on a mortgage. Suppose you're applying for a $300,000, 30-year fixed-rate mortgage.

• Scenario A: High Utilization (Lower Credit Score)
• Your high credit utilization results in a credit score of 680.
• Lender offers an interest rate of 7.5%.
• Estimated Monthly Payment: Approximately $2,098.
• Total Paid Over 30 Years: Approximately $755,280.

• Scenario B: Low Utilization (Higher Credit Score)
• Your low credit utilization results in a credit score of 760.
• Lender offers an interest rate of 6.5%.
• Estimated Monthly Payment: Approximately $1,896.
• Total Paid Over 30 Years: Approximately $682,560.

Difference: In Scenario B, with a better credit score due to optimized credit utilization, you would save approximately $202 per month, totaling over $72,000 over the 30-year loan term. This significant saving highlights why managing your credit utilization is a fundamental strategy for any serious real estate investor.

Common Misconceptions About Credit Utilization

There are several common myths about credit utilization that can lead to poor financial decisions. Understanding these can help you avoid pitfalls.

Myth 1: Closing Accounts Helps Your Score

Many people believe that closing old credit card accounts, especially those they don't use, will improve their credit score. In reality, the opposite is often true. Closing an account reduces your total available credit. If you still carry balances on other cards, your credit utilization ratio will immediately increase, potentially lowering your score. It also shortens your average credit history, another factor in your score.

Myth 2: Carrying a Small Balance is Good

Some believe that carrying a small balance on your credit card and paying interest is necessary to build a good credit score. This is false. You can build excellent credit by using your card and paying the full statement balance by the due date every month. This way, you demonstrate responsible usage without incurring interest charges. Paying in full is always the best strategy for your finances and your credit score.

Myth 3: Only Credit Cards Count

While credit cards are the primary type of revolving credit that impacts utilization, other forms of revolving credit, like personal lines of credit, can also be factored into your overall utilization. Installment loans (like mortgages or car loans) are different; they have a fixed payment schedule and are not typically included in the utilization calculation, though they do impact your debt-to-income ratio and overall debt burden.

Conclusion

Credit utilization is a powerful lever in your financial toolkit, especially for real estate investors. By understanding how it's calculated, its profound impact on your credit score, and implementing strategies to keep your ratios low, you can significantly improve your chances of securing favorable financing for your investment properties. Responsible credit management, with a keen eye on utilization, is a cornerstone of successful real estate investing.