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There is a common misconception that carrying a balance on credit cards improves your credit score. The truth is credit history improves your credit score. This can be confusing and can read contradictory, which results in credit card users holding some amount of debt. Any time you use a credit card and make payments, you are creating credit history. There is no need to hold a balance to create this history. Paying credit card statements in full and on time each month will work more in your favor when improving your credit score, giving you good credit history and saving you money on interest charges. Let’s explore the effects of carrying a credit card balance on your credit score below.
Keeping Credit Accounts Open
Some people believe the only way to show you are an active user of a credit card is by keeping a balance on the card. This is untrue — all that is required to keep a credit card open is some activity. This activity can be as small as an automatic monthly Netflix subscription and a payment from your bank to cover the cost of the subscription each month. Not only will this simple financial habit keep an account open, but it will also add ongoing credit history to your credit report. Keeping credit cards open and in use will maintain credit limits and add to your overall credit utilization by not losing credit available from existing credit cards.
This is the amount of credit you use each month. Let’s say you have a total credit limit between two credit cards of $5,000 and you charge $1,000 every month to your credit cards and pay those charges in full every month. You would be using 20% ($1,000 / $5,000) of your total credit limit each month. In other words, your credit utilization in this scenario would be 20%. The lower your credit utilization every month, the better your credit score will be. It is said that credit card holders should maintain a credit utilization ratio below 30%, which would be no more than $1,500 used and repaid each month if you have a total limit of $5,000. When you do not carry a regular balance, you make it easier for yourself to stick to a lower credit utilization ratio, which will improve your credit score. Credit utilization accounts for approximately 30% of your overall credit score, it’s a big way your credit score is determined, and it is highly recommended to keep it low so your credit stays high.
Something to consider is also spreading credit utilization out evenly among credit cards, as a high credit utilization on one credit card doesn’t read well on a credit report either. In the above scenario, you’d want to put $500 on each of your credit cards. Let’s say they each have a credit limit of $2,500, you’d maintain the 20% credit utilization in total credit available and for each card. This will affect your credit score less but is something to be aware of, especially if you do end up carrying any amount of balance.
Interest VS Credit Card Rewards
If you have a credit card for the amazing rewards it offers, with cashbacks or points used for purchases, carrying a balance makes these rewards essentially cancel out. Credit card companies make most of their money from interest. If you carry a balance on your credit card, you are accruing and paying interest. The people who pay interest make credit card rewards and incentives possible, credit card companies only offer these things for the chance to earn money from lingering balances. If you get a credit card for all it’s rewards, they are really only rewards if you do not end up paying ridiculous amounts of money in interest. Otherwise, any rewards you’re getting could have been given directly to you from you. Paying balances in full will ensure you do not pay any interest and will ensure you get all the perks of credit card rewards.
Good financial health means living within your means. While credit cards may give you access to more purchasing power, you should always be responsible. Living outside of a budget and carrying even small balances from month to month could potentially add up to significant amounts and can push your credit utilization way up. On time payments and low credit utilization are the main ways credit scores are decided. Only spending what you can afford and paying balances in full each month will help meet the on-time payment and low credit utilization consideration of your credit score.
Reality of Credit Cards
Many people have credit cards for emergency situations; repairs they weren’t anticipating, or unforeseen travel expenses. While good financial health includes emergency savings, not many people carry the recommend amount of savings for monthly bills or surprise costs. A lot of people turn to credit cards to make the difference and pay for the unexpected. These situations happen, and with good financial habits of regularly living within your means and always paying the minimum payments on time. Even individuals in these situations can keep their credit scores from completely sinking and work to create budgets to repay surprise debts as quickly as possible. Carrying balances will not help build your credit score and having balances that put your credit utilization above 30% can be harmful. In these situations, work smart and quickly to get credit utilization under 30% and always pay balance in full when possible.
Live within in your means and always pay balances in full, by not overspending. Have credit utilization as low as possible so you are never going above a 30% credit utilization ratio, even in emergencies if possible. Make payments on time, keep credit cards open and active, even with small, automated subscriptions and payments. Maximize your borrowing power by maintaining a high credit score and keep good credit history. Low-to-no balances and higher credit limits will signal more financial stability, keeping your credit score healthy.