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The Small Business Owner's Guide to Credit Utilization

ByMeredith Wood,
business.com writer
|
Dec 26, 2016
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> Finance
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The importance of a small business owner’s credit score cannot be underestimated

When it comes to qualifying for extra capital, the importance of a small business owner’s credit score, especially for an owner just getting her business up and running, cannot be underestimated. Because your business has little or no credit of its own, lenders will look to your personal score as a means of indicating how you will manage your business finances. 

So what does this score represent?

The FICO calculation is designed to forecast how likely you are to default on debt in an 18-month window, giving lenders an indication of your creditworthiness. And for small business owners, this means business lenders, too. 

Here’s how your FICO score works.

Credit utilization and your FICO score

Your FICO score is based on five key elements: your payment history (35 percent), the length of your credit history (15 percent), your credit mix (10 percent), how much new credit you have (10 percent), and the total amounts you owe (30 percent).

The amount you owe, or how much credit you’re using—also known as credit utilization—comprises almost one-third of your credit score. And though it may seem straightforward, some nuances are often overlooked.

In addition to representing the total amount of your outstanding credit, credit utilization is also a marker on your ratio of outstanding debt relative to your current credit limit.

Installment and revolving credit

To understand why this is so important, it’s good to review both installment credit and revolving credit.

Installment credit is a term loan with pre-determined payments, such as a mortgage, car or student loan. It’s also like a traditional term business loan, in which you receive a lump sum and agree to pay back that amount plus interest in specific increments over a set amount of time.

In relation to your credit utilization with a term loan, your utilization ratio (or the ratio of the amount you owe) will be very high at the start of the loan. But, as you make payments, your utilization ratio will decrease over the life of the loan, as you owe less over time. Your FICO score is generally less affected by installment credit then it is with revolving credit.

That’s primarily because, with a revolving credit account, as you pay back the amount you’ve borrowed, you are able to borrow those same funds again within your pre-approved credit limit. This is similar to a line of credit or credit card.

If you have a credit card with a $10,000 limit, and you spend $5,000—you have a 50 percent credit utilization ratio, since you’ve used 50% of the credit. For each $1,000 you repay, you decrease your utilization ratio by another 10 percent. But if you spend $1,000, your utilization ratio goes up 10%. You can see in this scenario that if you’re spending outpaces your payments, your utilization ratio could increase quickly, negatively impacting your FICO score.

Why credit utilization matters

Credit utilization is such a big part of the FICO score equation because it identifies borrowers who are just one move away from becoming delinquent on their repayment obligations—an important factor for lenders when considering loan recipients.

Borrowers who maintain high levels of revolving credit—and in turn, credit utilization—are financing their lifestyles by using very expensive debt. This is because carrying a monthly balance comes with high-interest rates. 

This type of behavior may suggest an individual is living paycheck to paycheck, so there’s little to no room for error in their personal finances. With only a small cushion, one surprise or mistake can come with a hefty price tag.

Credit utilization guidelines to follow

An ideal credit utilization ratio is less than 30 percent, however, the lower, the better. Taking steps to pay down credit card and other debt will help both your credit score and your future borrowing potential. 

Keep in mind that your FICO score is meant to be a tool that works for you. It provides guidelines to navigate your credit choices by not taking on more credit than you can handle. Lenders also avoid opening accounts with people who have low credit scores or high credit utilization because of the risk of those borrowers not being able to pay back what they owe.

Ultimately, your credit score is an indicator of whether or not it’s wise to take on additional financing. Keeping your credit utilization in the less than 30 percent range will help boost your credit score and qualify for extra capital when you need it.

 

Photo credit: danielfela/Shutterstock

Meredith Wood
Meredith Wood
See Meredith Wood's Profile
Meredith Wood is the Editor-in-Chief at Fundera, an online marketplace for small business loans that matches business owners with the best funding providers for their business. Prior to Fundera, Meredith was the CCO at Funding Gates. Meredith is a resident Finance Advisor on American Express OPEN Forum and an avid business writer. Her advice consistently appears on such sites as Yahoo!, Fox Business, Amex OPEN, AllBusiness, and many more. Learn more at www.fundera.com
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