When You Don’t Spend Enough: Understanding Credit Utilization

There’s a common saying in many circles of wisdom: that less, is more. You’ve probably heard it uttered by dozens of artists, interior designers, business managers, and auto salesmen. You may have even used it yourself a time or two. Regardless of where it came from or who uses it most, the principle remains unchanged: that more is not always better, and sometimes you’ll get better results by making reductions.

In many cases, this nugget of wisdom holds true. You see it plainly in those “Buy two, get one free,” deals, where you’re getting more for overall less money than you’d normally pay. Another great example is in paper towels that allow you to choose between different sheet sizes when you tear off a strip, so you don’t waste as much paper.

But when it comes to credit, an area where you would think that not spending as much would always be a good thing, you might be surprised to find out that you may need to spend a little more, if you want to increase your overall credit score. This is because credit utilization plays a role in determining your score, and if you’ve never encountered it before, you may not understand what it is, or how it works. Below, I’ll discuss with you what credit utilization is, and help get you on the right path to using it in your favor.

What is Credit Utilization?Credit Utilization

Credit utilization refers to the ratio of how much total available credit you have, versus how much of it you spend at a time. Take, for example, a credit card: they all have a built in monthly credit limit, and if you exceed that limit, your card will start being declined.

To calculate your credit utilization percentage, say using a credit card with a $10,000 limit, take the amount you spent that month, and divide it by $10K. If you spent $4,000, your credit utilization ratio on that particular card would be 40%.

Bear in mind, your credit utilization ratio is calculated across all of the total credit you have available, not just credit cards. Other examples of credit could include a car loan, student loan, and a line of credit through your bank.

How Does it Impact my Credit Score?

When credit reporting agencies compile your cumulative credit score, they factor in your credit utilization ratio as a factor to see how reliant you are on credit. If your credit utilization is high, it indicates that you may rely more on other people’s’ money, rather than your own assets, to afford what you buy. Conversely, spending very little credit indicates that you may be taking out credit for no reason other than, “just to have it.”

The risks associated with the former instance are obvious. If your utilization is high, you’re much more liable to overspend, and fall into debt. This will result in a lower score, because you’ve clearly indicated that you’re a more risky investment for lenders, creditors, and other financial agencies.

But spending too little of your credit can also cause your score to drop, or at the very least, not improve. This is because, when you spend very little credit, you both broadcast the impression that you’re terrified of credit, and you make it difficult to establish patterns of responsible behavior. Think about it like this – if I were a personal fitness trainer, and had a client who maintained a membership, but they never came into the gym, how can I really know if they’re being fit, or performing exercises safely? They might be working out at home, they may not be – I have no way of knowing.

The same is true of your credit score. The biggest component of your score is your credit history, or the number of times you’ve paid your bills, including any missed or late payments. If you have access to credit, but never use it, how will a credit agency know that you can manage it responsibly?

The bottom line is, you need to spend some credit, but not overspend.

How Can I Utilize Credit Responsibly?

As a general rule, your credit utilization should never exceed 30%. While some agencies understand that things in life happen, and sometimes your credit is the only way out of a situation, you need to stay at or below that ratio as often as possible. The nice thing is that credit agencies update and report your data, on average, every 31 days. This means that if you did have to spend, say, 45% of your credit limit this month, due to a medical emergency, your score may drop this month, but as long as you pay off your bill in full, your score should start to recover soon.

On the opposite end of the spectrum, I’d recommend you spend at least 10% of your credit limit each month. That way, you do have a balance, and payment due date, that you’ll have to manage, and you have the opportunity to demonstrate that you’re responsible with your credit.

How Can I Avoid Overspending?

There are two methods that I’d recommend to avoid overspending, and whether you use one or the other, or both, will depend on your own circumstances.

First, you can simply request that you receive an increased limit on your credit card. If you have a higher limit, it will require you to spend more before you exceed that 30% ratio. Bear in mind – while this might keep you in good with creditors, it will also increase the amount that you’ll have to spend to hit the minimum five percent you need to keep a concurrent credit history going. Ten percent of $100K is still $10K, and that’s a lot of money to spend all at once.

I’d recommend that you first see how much you spend each month on average, that you’ll absolutely be buying no matter what, such as gas and groceries. Once you have that total, calculate what limit where the amount you’re spending would be 10%. For example: if you spend $500 a month on gas and groceries, make sure your card has at least a $K limit. Now you can comfortably make all those purchases on your card, without worrying about either exceeding your limit, or spending enough.

The second option I could recommend is to take out a second card, with a smaller limit, and spread your purchases between the two cards. That way, you’re still spending the same amount, but you don’t have to make as many purchases per card to start generating data.

As a final word of warning – anytime you apply for a new credit card, and often when you request an increase on your credit limit, there’s going to be a hard inquiry made against your credit score and report. Hard inquiries will lower your score anywhere from 5 to 20 points, which isn’t a big deal on its own, but coupled with multiple inquiries at once, your score can quickly take a nosedive. Wait four to six months in between new applications.