How maxing out your credit card affects your credit score

There are a lot of factors that determine what your credit score is, and this week we’re focusing on the second-largest factor and one that a majority of Canadians aren't aware of: utilization ratio.

Your utilization ratio is your level of indebtedness, or how much of your total available credit you’re using. For example, if your credit card limit is $1,000 and your balance is $1,000, your utilization ratio is 100 per cent — and this not good in the eyes of the credit bureau. Credit bureaus base credit scores on behaviour with credit. If you're constantly maxing out your credit cards, it could imply that you're not far away from defaulting on your minimum payments. It looks like your income is stretched.

There are two rules for utilization ratios. One rule is for those who pay off their balances in full every month, and the other is for the 46% of Canadians who carry a monthly credit card balance.

Don’t ever let your utilization ratio go over 70 per cent. For example, if you have a small business and want to build up points, you may put all your expenses on your credit card every month. You pay this off at the end of every month, but your credit card company reports your balance to Equifax (the largest credit bureau in Canada) two days before you pay the balance off in full. When your score is calculated, it will show that you maxed out your card. I see this scenario with many successful business owners who don’t have the best credit scores for this very reason.

If you tend to carry a balance on your credit card, try to keep it under 35 per cent. There are two reasons for this. First, this is close to the magic number for utilization ratio and contributes to a strong credit score. The other reason is that it helps you put a cap on racking up debt that might not be manageable. When a credit card company increases your limit, it is not necessarily looking at your entire personal budget and might not be aware that you can afford to spend the maximum and pay it off in a timely manner. You are responsible for setting these imaginary limits for yourself to stay in control.

Approximately 30 percent of your credit score is made up of your utilization ratio. Fixing your utilization ratio is one of the fastest ways of improving your score, so if you have a habit of accumulating credit card debt, make a payment and your score can increase quickly.

It’s important to know your credit score well in advance so that you aren't surprised when you're shopping for credit. Ideally, you should also be aware of how it changes from month to month.