Credit is a rather confusing topic. There is often more rumor than reality, more fiction than fact.
One of the most common of these rumors, is that you need to carry a balance on your credit cards, in order to build and enjoy a strong credit score. In other words, you shouldn’t pay off the full amount you spend each month, but rather, leave a small amount unpaid (earning interest). Is this true? Let’s take a look.
Paying Your Credit Card Balance
Let’s say you have a credit card, on which you spent $100 last month. Let’s also assume that this card carries a limit of $1,000.
Each month, you’re required to make a payment, based on the previous month’s spending (unless you spent nothing that month, in which case you would owe $0). You could pay the minimum amount due, which is usually calculated based on the interest rate on the card, as well as how much you spent that month (sometimes combined with spending from previous months). In this case, let’s say your minimum payment is $13.
Let’s assume that the due date on your card (for the previous month’s spending), is the 1st of the following month. On that date, you have four options.
One is to pay the minimum amount due ($13). You will owe interest on whatever balance remains on the account.
Another option is to pay off the full balance on the card. If you choose to go this route, you’ll avoid making any interest payments, since you’ve paid off the entire amount you owe (and spent) on this account.
You might also pay some amount in between the minimum amount due, and the $100 which you spent on the card. Perhaps you have other financial obligations as well, so you choose to pay off $40 of your credit card balance.
Technically, you have a fourth option: Don’t make your minimum payment on the card. However, this will result in your account being marked 30 days late (or more, if you fail to pay in subsequent months). Obviously, this will greatly harm your credit score (and if the debt is large enough, could result in you eventually being sued on the debt). So, we won’t discuss this option any further.
How Balances Are Reported To Credit Bureaus
Whichever option you choose, it is now important to understand the next step of the process: Generation of your credit card statement. Your credit card statement is normally prepared at least several days (sometimes as much as a week) after the due date on your card. Your statement lists all spending during the previous 30 days, as well as your balance on the card, as of the statement date.
So, in this example, your card’s due date was the first of the month, and your card statement might be prepared around the 8th of the month. Your balance on the card is reported to the credit bureaus on, or shortly after, your statement is prepared. So, in this example, your balance as of the 8th of the month, is what appears on credit reports.
Let’s pause for a moment here, and think more about what is happening. You paid your credit card balance off on the 1st, and a statement was generated a week later. Suppose you spent $100 during from March 1 to March 31st.
On April 1, you paid off your balance of $100, so you now have a balance of $0. Let’s also assume that you did not spend any money between April 1 and April 8 (when your statement is generated). What balance reports to the credit bureaus? $0, since that is what appears on your statement date.
Now, let’s change the scenario a bit. Let’s assume once again that you spent $100, and paid off the balance on April 1, leaving you with a $0 balance.
Now, let’s say between April 1 and April 8 (perhaps on April 5), you make a relatively large purchase – $300 for a new computer. Your statement will now list a $300 balance, which is what will appear on your credit reports. Even though you paid off your balance in full last month (leaving you with $0 balance), your spending since then leads to a higher balance being reported.
We now understand how credit card balances are reported to credit bureaus. Now, does carrying a balance help your credit score?
How Credit Card Balances Impact Credit Scores
As a general rule, the higher your credit card balances, the more your credit score drops. As your credit card balance increases drastically, then, generally speaking, your credit score will drop further.
With that said, as long as your balance (again, as of the statement date), is below 30% of the limit on your card, your credit score should probably be in a good position. If you’re able to reduce your balances even further, your score will improve even more. So, having a balance of 10% is better than having a balance of 30%.
Here is where it gets tricky. The ideal balance to show on a credit report is between 1% to 5% of the card’s limit, not 0%. In fact, a balance of 0% often reduces your score slightly, as compared to a balance between 1% to 5%. Why is this? Why, in this case, does a lower balance reduce your FICO score?
A 0% balance suggests that you’re not actually using the card. If you aren’t using the card, then how can we really say that you’re effectively managing the account? It doesn’t take much financial savvy to throw a credit card in a drawer, and never touch it again. However, it does take some skill to use a card smartly each month, not overspending, even though you have the opportunity to do so.
This might not seem fair, but as with so many things involving credit, we have limited control over how FICO chooses to score our credit data. So, the question becomes, how can we use our knowledge of FICO scoring, to enjoy the very best credit score possible
What Should You Do?
First off, let’s keep in mind when your credit score actually matters the most: When you’re applying for credit. If you plan to start shopping for a home in 2 months, you should be very concerned with, and aware of, exactly where your credit score falls. The same is true if you’re shopping for an auto loan, or even a new credit card.
If you’re not planning on making this sort of purchase in the near future, you should still be concerned about your FICO score. However, it is not as important whether you have a 710 to a 750 FICO score, unless you’re applying for credit in the near future.
For this reason, if you’re paying off a card in full, and showing $0 balance when the card is reported to credit bureaus, you should not be too concerned. However, if you’re planning on applying for credit soon, you might want to make a small purchase (let’s say for around 2% of the card’s limit), between the date you pay off your balance, and the date your statement is prepared. If you have a card with a $1,000 limit, this means you make a purchase (something you might have needed anyways), for around $20.
Through this approach, you’re able to enjoy the strongest credit score possible, and get the best rates and terms on a loan. At the same time, you’re not unnecessarily spending money to show a balance, and preserve your credit score.
