Credit scores are some of the most important, but least understood, part of personal finance. One common misconception on the subject is that keeping a balance on a credit card from month to month is better for your score than paying it off in full every time you get a bill.
In this segment of Industry Focus: Financials, The Motley Fool's Gaby Lapera and Jordan Wathen talk about how balances impact your credit score, and why carrying a balance is a bad way to get a higher credit score.
A full transcript follows the video.
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This podcast was recorded on March 20, 2017.
Gaby Lapera: "I'm interested to hear your thoughts on whether it's worth it to carry some debt on your credit card from month to month as a means of building your credit rating. I've always paid off each statement's worth of balance by the due date each month which, as someone who doesn't anticipate any large loan-worthy purchases in at least the next year, has seemed like the most money-saving route to take. However, someone mentioned that credit card companies may prefer to see consumers actually 'managing' their debt rather than paying it off. I'd like your opinion on this matter. The only other type of debt I've had up until this point in my life are my student loans, which I have been paying consistently for years, both on my own and with some help from my parents. We'll have them all paid off ahead of schedule."
So, this is a great question, and this is actually one of the most common misconceptions that I see, and I have no idea where it started, but I've heard it from literally dozens of people, maybe even tens of dozens -- no, that's an exaggeration. But, you do not need to carry a balance on your credit card in order to build your credit. You just don't. In fact, it's probably best that you pay off your account in full every month, because it's going to drive down your credit utilization ratio, which is a big part of how the bureaus calculate your credit score. It's also going to make it easier for you to budget, because your card is always paid off, so you know how much you owe at any given time, and you don't have to make interest payments on anything, which is also huge. I think a lot of people don't add in the idea of interest when they have carry over from month to month on their credit cards.
I think the origin of this idea that you don't want to pay off your credit card in full every month -- I think people might have that confused with, you don't want to pay off your credit card as soon as a charge hits it every time. And I do know some people who have done that in the past. They go to Starbucks and spend $5, and they go to the supermarket and spend $50, and at the end of the day they eat a cruller, and it's $2. Then, at the end of the day, they pay off that $57, instead of letting it sit on their credit card. But you don't really want to do that because what happens is, at the end of the month, the bank or the credit card company or whoever owns your credit card sends your statement over to the credit bureaus, and if it's $0 for long enough because you've been paying it off before, sometimes the credit bureaus will think your credit card is no longer active and shut down your credit line. Or, it'll say that you don't have an active credit line anymore, and that will drive down your credit utilization ratio. But, that's very rare, that doesn't happen very often.
But, ideally, what you should do is pay it off once a month in full, every month. If you're really worried about your credit utilization ratio being high, pay off half of it, if you're worried about, for whatever reason, the credit bureaus thinking your credit line is no longer there. Pay it off a little bit, and that will help keep your credit utilization ratio low. It'll let the credit bureaus know that your card is still active. And it'll just be great.
Jordan Wathen: Right. This actually drives me nuts, because honestly, there's probably a one-point benefit to somehow carrying a balance. But in the grand scheme of "Does your credit score matter?" the one point is not relevant. It's completely irrelevant. It doesn't matter to anything. But they can say that's true, so it's like, "Hey, pay us more interest," right? So, it's one of those cases where you can over-optimize, and end up paying $5 for one point on your credit score that makes no difference whatsoever.
Lapera: Yeah, that's true. The credit card companies care more about whether or not you're going to pay on time, and that you're not using so much of your credit utilization ratio that it's out of control. They care more about those things in terms of trustworthiness rather than you having interest. And honestly, long term, if you have a lot of interest, that is bad.
Wathen: Right, that's terrible. You never want to pay interest on a credit card. You can honestly have an 800 credit score just by paying on time and making sure your credit utilization ratio is never over 15%. Then, you're probably solid, right? It's really not that complicated. I feel like they make it almost too hard, or, we try to explain it to such a depth that doesn't matter. But really, just pay your stuff on time, and ideally, try to never cross 15%. I know that's under the 30% threshold that everyone quotes, but that makes it a little bit easier, and you'll never cross that barrier. It's super simple.
Lapera: Yeah. It's really not a huge deal. I think, for me, one of the reasons this makes me kind of panicky when I hear it from people is that I know that a lot of people aren't very good at budgeting to begin with, and then they're trying to carry a balance every month, and they're paying interest on it, and I can see that situation rapidly spiraling out of control.
Wathen: Right, and there's another thing: A credit score only matters at the point in time when you need it. For example, my friend, he called me up one day and said, "Man, my credit score is really low but I paid everything on time." And the reason was, he had a card with a super low limit, maybe it was $500 to $1,000, and he would use it for everything that month and then pay it off in full. It wasn't a big deal, he would never go over his credit limit or anything. But, when they took that snapshot in time, it would say he was 60% or 70% utilization. So, he asked me about it, and I said, "Just stop using it for a month or two when you know you're going to need a good credit score." And he did, and his credit score jumped 70 or 80 points. Which is the difference between prime and subprime, in some cases. It's a big deal.
Lapera: Definitely. The other thing that you could do is open another credit card, and that'll increase your total credit limit, and use it rarely. There are definitely multiple ways to play the system. And technically, yes, opening a credit card will make your credit score dip, but it's only by a couple points for a few months, and then it'll go right back up, because your credit utilization, the total amount of credit you have, is much higher.
Wathen: Right, that's what I'm saying. That's what I feel like is why people don't understand this. There are things that are true for three or four points. But in the grand scheme of things, three or four or five points on a 700 or 800 score does not matter. Your lender is not going to deny you over three or four points. You know what I mean? Just get the big things right, and forget about everything else. I think I have a really good credit score, I could get really good low interest rates, and all I do is pay stuff on time.
Gaby Lapera has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Starbucks. The Motley Fool has a disclosure policy.