When you’re applying for a small business loan, understanding how lenders calculate and use the credit utilization ratio will empower you to get better credit terms.
This is just one factor that goes into your credit score and lenders’ credit decisions, but it makes a big impact on both. As you work to improve your ratio, you’ll see positive impacts in your credit score and the terms you’re offered by lenders and creditors.
In this overview, you’ll learn all about the credit utilization ratio: what it is, why it’s an important factor in determining creditworthiness, and how you can calculate and improve yours before you apply for funding.
What is credit utilization? Understanding your credit utilization ratio
Credit utilization refers to how much credit is available to you at a given time. In this case, “utilization” is just another way of saying “use,” and it can refer to your available business or personal credit.
The credit utilization ratio, then, is the amount of credit you’re using relative to the total maximum amount of your credit sources, presented as a percentage.
When creditors and lenders review your applications, your credit utilization ratio is a significant factor in determining whether you’ll be approved for a credit card or loan. According to Experian, a leading credit-reporting agency, your credit utilization ratio can make up 20-30% of your overall credit score, making it as important as on-time payments.
Generally speaking, creditors and lenders require credit utilization ratios of 30% or less. If you have a credit utilization ratio of 10-20% or less, along with an excellent payment history, you’re more likely to be offered the best terms.
Keep in mind that your credit utilization ratio isn’t something you necessarily need to worry about on a day-to-day basis. While you certainly want to be aware of how much credit you’re using, and how that impacts your overall financial picture, your ratio will really come into play when you’re getting ready to apply for financing or more credit.
How to calculate credit utilization
Calculating your credit utilization ratio is easy. Simply:
- Add up the total of the outstanding balances for each of your credit accounts.
- Add up the total of the maximum credit limits from your different credit accounts.
- Divide the total of your outstanding balance (the amount from #1) by the maximum combined credit limits (the amount from #2), then multiply that by 100 to get your credit utilization percentage.
Here’s an example: Let’s say that for your business, you have a credit card with a $10,000 maximum and a business line of credit for $20,000. Without any charges against either of these, you have a maximum credit availability of $30,000.
Now, let’s say that you use $5,000 on the business credit card to buy equipment and you use $10,000 from the line of credit on inventory for the upcoming summer season. Your credit usage is now $15,000 out of your maximum credit of $30,000:
- Outstanding balance: $15,000
- Maximum credit limit: $30,000
- Credit utilization ratio: (Balance/limit) * 100 = (15,000/30,000 = .5) x 100 = 50.
You now have a 50% credit utilization ratio.
Steps to improve your credit utilization ratio
Credit utilization ratios are always changing, so it’s important to use credit carefully and time purchases wisely if you may be seeking a business loan or other financing soon.
In the earlier example, for instance, your ratio would have been lower before your inventory and equipment purchase than after the purchase.
A high ratio isn’t necessarily a sign that someone uses credit irresponsibly. But it can sometimes be a red flag for lenders that you may be struggling financially or that you’re overly dependent on credit. This can lead to higher interest rates or even a denial from a lender.
On the other hand, having credit but never using it can also work against you, as you can’t build a credit history if you don’t use credit. According to NerdWallet, people who have credit utilization ratios of 1-10% tend to have the highest credit scores.
With that in mind, here are four proven ways to improve your credit utilization ratio:
1. Pay your balances more frequently
You don’t have to wait until a loan payment or credit card bill is due to make a payment! You can make payments as frequently as you’d like to better manage your credit balances.
- Pros: For credit cards, you can pay off purchases as soon as they’re posted to your account, which builds a strong credit and payment history while keeping your utilization ratio low. For loans, making payments twice a month reduces the outstanding principal balance faster. You’ll pay less in interest over the course of the loan and reduce the length of time that the loan is open.
- Cons: Before you make additional or more frequent payments, ensure that your business’s revenue cycles can align with this change – otherwise, you could end up straining your cash flow. For example, if you pay down credit card and loan balances early in the month but your clients typically don’t pay you until later in the month, you may have a couple of weeks in which you’re strapped for cash, which could lead to using even more credit.
2. Increase your credit limits
Because credit limits are one of two key factors in your overall ratio, having higher credit limits can be a strategy to improve your credit utilization ratio. You can contact your creditors to ask for an increase. Even a modest amount from each source can make a significant difference in your overall ratio.
- Pros: If you’re responsibly using credit, increasing your maximum credit limit – without also increasing your utilization – can quickly improve your ratio.
- Cons: For a variety of reasons, some people use whatever credit is available, whether it’s $500 or $50,000. If that sounds familiar, you’ll need to be cautious if you request a credit-limit increase to help improve your ratio. You may want to raise the limit to achieve a near-term financing goal (such as applying for a small business loan), then ask to have your credit limits lowered again after the loan has closed so you’re not tempted to use more credit.
3. Spread balances across multiple cards
If you have several credit cards but tend to use just one or two, then the higher balances on those cards can skew your overall ratio. A better strategy may be to spread your purchases over several cards.
- Pros: Using different cards – and paying at least the minimum due for each card every month – can lower the utilization ratio for each, which can result in a lower overall score.
- Cons: If having many cards will make it too tempting to run up credit use, then this strategy is more likely to work against improving your ratio.
4. Regularly monitor your personal credit reports
Errors happen – incomplete, incorrect, or even fraudulent information can end up on your personal and business credit reports. If there’s incorrect information about your credit use or your credit limits, an inaccurate credit utilization ratio is one of the many problems that can result.
- Pros: Although it can take time to resolve, correcting any problems on your credit report can result in a higher credit score and better utilization ratio.
- Cons: Creditors and reporting agencies rarely identify mistakes or misinformation on their own, so you have to be proactive about reviewing your reports. Otherwise, you can end up with incorrect information that can be damaging to both your personal and business credit histories.
Pursuit has financing options that help
If you’re preparing to apply for a small business loan or line of credit, take time to calculate your current credit utilization ratio. If it’s at or over 20-30%, you’ll want to pay down balances before you apply to help you secure more offers with better terms.
When you’re ready to apply, talk to Pursuit! We offer more than 15 business loans and a line of credit that are designed to support small business success. Our goal is to ensure all businesses have a path to success, so our loans all come with competitive rates and terms that make it easier to pay down balances and improve your cash flow.
Thousands of businesses have found financing with Pursuit – is yours next? Take a look at your options, then contact us to learn more.
