If you're carrying a credit card balance, you're not alone. The typical U.S. household with outstanding debt is about $16,000 in the hole, and that's just the average -- there are those who owe considerably more.
Continue Reading Below
Not only will carrying a credit card balance subject you to an ongoing cycle of interest charges, but it might also end up destroying your otherwise good credit score. On the other hand, if you manage to pay off your balance in full, you'll improve your credit utilization ratio, thus boosting your FICO score and making it less expensive to borrow in the future.
How paying off your balance will help your credit score
To understand why paying off an outstanding balance can help your credit score, you'll need to learn more about how that number is figured. There are five key factors that go into calculating a credit score, each of which carries a certain amount of weight:
- Payment history (35%) reflects your ability to pay your bill on time consistently.
- Credit utilization ratio (30%) represents the percentage of your available credit that you're using.
- Length of credit history (15%) speaks to the length of time you've had your credit accounts open.
- New credit accounts (10%) refers to the number of accounts you open within a short period of time.
- Credit mix (10%) represents the various account types you have.
As mentioned above, paying off a credit card balance can help with your credit utilization ratio, which makes up 30% of your score. And that's reason enough to pay off your debt.
Continue Reading Below
What is credit utilization?
Your credit utilization ratio shows how much of your available credit you're currently using. For that ratio to help your credit score, it needs to stay at 30% or below. This means that if your total line of credit is $10,000, and you have an outstanding credit card balance of $4,000, your utilization ratio will be 40%, and that will hurt your score.
Keep in mind that it's possible for one person to have racked up more debt than another, yet still have a lower credit utilization ratio. If you owe $4,000 on your credit card and your total line of credit is $10,000, you'll be in worse shape credit scorewise than someone owing $5,000 with a $15,000 line of credit.
Either way, if you're carrying a balance, the sooner you pay it off -- or even partially pay it off -- the more your credit utilization ratio will drop. And once that happens, your score will start to improve. In our example, paying $1,000 of your $4,000 outstanding balance will send your credit utilization ratio back into favorable territory. And that's motivation to work on eliminating your debt.
Pay off that balance as soon as you can
Credit score benefits aside, there's another reason to work on paying off your credit card balance: The sooner you do, the less interest you'll continue to rack up, and the less money you'll end up throwing away.
If you're dealing with a balance on a single credit card, your approach to paying it off is pretty simple: Cut some corners, or work a side job to generate extra cash, and use that money to pay off your debt. Another option? Find a card with a lower interest rate, and transfer your balance over.
If you owe money on multiple credit cards, you can also try transferring your various balances to a single card with a more favorable rate. If that's not an option, then review your balances, see which ones have the highest interest rates, and pay those down before moving on to your remaining cards.
Paying off credit card debt quickly is the smart thing to do if you want to stop wasting money on interest and improve your credit score at the same time. If you're applying for a mortgage, car loan, or any other sort of financing, a strong credit score could spell the difference between getting denied or approved. And the higher your score, the better a rate you're likely to snag -- which could help save you loads of money in the long run.
5 Simple Tips to Skyrocket Your Credit Score Over 800!
Increasing your credit score above 800 will put you in rare company. So rare that only 1 in 9 Americans can claim they're members of this elite club. But contrary to popular belief, racking up a high credit score is a lot easier than you may have imagined following 5 simple, disciplined strategies. You'll find a full rundown of each inside our FREE credit score guide. It's time to put your financial future first and secure a lifetime of savings by increasing your credit score. Simply click here to claim a copy 5 Simple Tips to Skyrocket Your Credit Score over 800.
The Motley Fool has a disclosure policy.