Credit scores, for better or worse, are an important measure of your overall financial health for most people. But since the exact formulas that calculate the scores are a secret there are a lot of myths about what can hurt and what can help your credit score. One of the most common is that carrying a balance on credit cards is necessary for a good credit score. In other words, that paying off your credit cards in full every month is hurting your score. This isn’t true.
Using your credit cards and paying off the balance in full every month is the best way to build a good credit score.
Let’s dig into why that is. Carrying a balance means you’re using some of your available credit which raises your credit utilization ratio and will lower your credit score. In general, as your credit utilization increases, your credit score decreases.
To estimate your utilization ratio take the total of credit you’re currently using (the balance on your cards) and divide it by the total credit available to you (the total of the credit limits on all of your cards.)
If you have 3 cards that each have a $2,000 limit you have $6,000 in total credit available to you. If you are carrying a balance of $100 on each card your total credit used would be $300. That makes your credit utilization $300 divided by $6,000 or 5%. Generally, the higher that number the worse your credit score will be. If each card had a balance of $200 instead the ratio would be (3 x $200) / $6,000 or 10%. The higher the balances, the higher the credit utilization. Some people even pay off their card balance twice a month to make sure that when their credit card company reports to the credit bureaus it doesn’t capture their mid-cycle balance between due dates.
The bottom line is carrying a balance when you don’t need to increases your credit utilization and hurts your credit score. Not only that, it means you’re paying interest to the credit card company just to keep your credit score low!
Now, like most persistent myths there is a grain of truth to it. Not using your credit accounts at all is not the same as using them and paying them off every month. If you open a credit card and never use it that isn’t viewed as a positive by your credit card issuer. It won’t necessarily lower your score, but it isn’t a positive either. “But that’s 0% credit utilization! I thought you said the lower the better?!” You’re right, we did. But credit issuers want to see you using credit responsibly. The key phrase there is “using it.” If you never pay for anything with your credit card you’re not using your credit. Using your credit cards to pay some bills or make some purchases and then paying them off in full every month remains the best way to demonstrate you’re using credit responsibly. That will result in a better credit score than carrying even a small balance every month, and save you money along the way.