Credit is a confusing topic. As a result, for many of us, it isn’t clear exactly how they go about building credit, maintaining their credit score, or dealing with bad credit.

One of the most common myths around building good credit, is that you have to go into debt – that is, you need to make interest payments, and owe money to lenders, in order to enjoy a positive credit score. This is not true. Let’s see why.

Your credit score is made of five factors: Payment history (which is 35% of your credit score), debt (30%), age of credit accounts (15%), mix of accounts (10%) and credit inquiries (10%). Two of these factors are most relevant to today’s discussion: Payment history and debt. 

Payment History

Your payment history measures, in a nutshell, how often you have paid on time (and paid late). Paying 30 days late once, on a single account, can reduce your credit score by as much as 80 to 100 points. Credit items which result from consistent late payments, such as collections and charegoffs, or the repossession of a car, foreclosure of a home, or bankruptcy, can have an even larger negative impact on your credit score. 

By contrast, if you always pay on time, across every account, you’ll enjoy a strong credit score for many years to come. Simply paying your bills when they are due, is the essence of being a trusted, creditworthy individual.

Debt

When it comes to credit scores and debt, there are several considerations. We’ll focus mainly on credit cards, rather than installment loans like student loans, auto loans, mortgages and personal loans. As it happens, your credit card balances have a greater impact on your credit score than even much larger installment loans.   

The first question is, what are your credit card balances, relative to the limit on each card? That is, how much was spent on the card, as of the date when it was reported to the credit bureaus? This amount, divided by your spending limit on the card, is your utilization ratio, or simply utilization, on the credit card.  

Ideally, your card’s utilization will be below 30% of the card’s limit – if possible, below 10% is even better. Your balance will usually be reported on the same date each month – which means if you know what you spent, you can predict what your utilization will be. 

Let’s say your credit card has a limit of $1,000. Now, suppose that the card reports to credit bureaus on the 10th of each month. As of that date, you have a balance of $200. 

This means your utilization will be 20%. In the following month, if you reduce your balance to $100 as of the 10th, your utilization has now dropped to 10%.

Here is another consideration: You need to look at your overall utilization, across all of your credit cards. Let’s assume that in addition to the card with the $1,000 limit, you have another credit card with a $5,000 limit. 

Let’s say that this card also reports to credit bureaus on the 10th of each month. Suppose you spend $1200 on this card, along with $200 on the card with a $1,000 limit. Your total balance is now $1400 ($1200 + $200) and your total limits are $6,000 ($5,000 + $1,000). 

This leaves you with a utilization percentage of 23.3%, across all your credit cards. This is the number which will ultimately impact your credit score. 23.3% utilization is not bad – it is below 30%, after all. However, below 10% is even better.           

What The Myth Says

The false belief says this: You have to carry a balance on your credit cards, in order to build a strong credit score. So, when your credit card bill comes due, because you are carrying a balance over to the next month, this will mean you pay interest on the card. Hence, building credit costs you money. 

The Truth

This isn’t true. Rather, it’s a product of the (understandable) confusion which exists around the credit system.  

With credit cards, having a utilization above $0 on one card, does in fact help your credit score. It makes it clear that you are using credit. However, you don’t need to carry a credit card balance, from month to month, to do this. 

Your utilization is determined by the date when your credit card issuer reports your balance to the credit bureaus. This is a specified, pre-determined date each month. 

Usually, your balance is reported to the credit bureaus, on or shortly after, the date when your credit card statement is generated. Then, 21 days after that (this is a legal requirement), your credit card payment is due. 

So, let’s say that your credit card minimum payment is normally due on the 2nd of each month. This means that your statement should be generated as of the 10th or 11th, and your balance reported to the bureaus around that time, or shortly after. 

If you have a small balance on one of your credit cards, as of the date the statement is generated, and no balance on the others, you’ll do quite a bit of good to your credit score. By reporting a balance on one of your cards, you’ve made it clear that you are making use of credit, but you are not going into debt to do so. 

You can then pay off your balance on the card, when it is due, and so avoid any interest charges. You’re building credit at no cost. 

Wait a minute. Aren’t you being forced into debt, by having to make purchases on your card (in order to enjoy good credit)? Not exactly. 

There are certain expenses which you’ll incur every month, and simply cannot be avoided. We’re talking about things like your utility bills, groceries, and cell phone or Internet. 

Why not use your credit card to pay one of those bills, and then pay off the balance? Why just 1? 

It’s very important that you build disciplined habits around credit. By using your card just once per month, for something you would have purchased anyways, you’re consistently cultivating these positive behaviors. 

Also, you should make sure that this purchase is for no more than 10% of your limit, on any particular card. So, if you have a card with a $1000 limit, perhaps you should use the card for a $50 cell phone bill – and pay off your $50  balance on the card in full, before the minimum payment is due. 

If you keep 2 open, active credit cards, using them in the manner described above, you should be able to enjoy a FICO score of 700 or higher. You’re building excellent payment history (by paying on time each month). You’re using your card wisely (i.e. not overspending), which means that your utilization is low. 

Even if you don’t choose to ever make any major purchases on credit (such as buying a home or car), you’ll be able to rent an apartment more easily with good credit, and save on your home or auto insurance. You’ve accomplished this by simply allocating your monthly expenses in a smart way, rather than taking on extra expenses or debt.   

The Final Word

To build a strong credit score, you need to use some form of credit. It isn’t possible to build a strong credit score without doing so. At the same time, you don’t have to make unnecessary purchases, or waste money on interest payments. Simply using a few credit cards, for basic expenses, and paying them off in full, on time, will allow you to enjoy all the benefits of an excellent credit score.