Whether it's better to maintain a balance or pay your credit card off in full each month is one of the most common questions about credit scores.
I recently received this question from a Money Talks News reader:
I’ve gotten some contradictory advice on carrying a credit card balance. When I was younger, my dad told me that carrying a balance was a good thing since it showed that you use credit, but I’ve read elsewhere that carrying a balance actually hurts your score.
Can you clear this up once and for all? Thank you! — Mike H.
Here’s my response
One of the biggest myths surrounding credit scores is that you need to be in debt to get a great score. The truth: You can have a high score with no debt. And carrying too high a balance can certainly hurt your score.
Before we get into what actually determines your credit score, we should mention that Mike’s dad wasn’t completely wrong. Showing creditors that you’re an active credit consumer does make you look more appealing to credit card companies and can improve your chances of card approval. But carrying a balance isn’t the way to do so.
If you want to show credit card issuers you’re serious about using credit, the easy way to do so is to make on-time payments in full each month. Carrying a small balance isn’t terrible in terms of your credit score. It’s when that balance climbs above 30 percent of your total available credit line that you could get into credit score trouble.
Your FICO score, explained
FICO inventors Fair Isaac Corp. actually set the record straight a while back in regard to what determines a FICO score, the most widely used American credit score model. They’ve said that the No. 1 factor determining credit scores is payment history, making up more than a third of your total score.
That’s why the best way to improve your score or maintain excellent credit is to make on-time monthly payments. Every time you make an on-time payment, you’re improving your profile in the eyes of creditors.
Obviously, in order to make a payment you need to actually use your card. Credit card inactivity does nothing to improve your score, and can actually hurt your score if your credit card company decides to close your account due to inactivity.
The second-biggest component of your FICO score, responsible for 30 percent, is called “Amounts Owed.” You can read about it at this page of the FICO website. It’s made up of six components, including one you can influence: your credit utilization ratio. That’s the outstanding balance of each debt relative to its limit. For example, if you have a credit card with a $1,000 balance and a $10,000 limit, you’ve utilized 10 percent of your available credit and have a 10 percent utilization ratio for that card. Each debt has its own ratio.
Some credit score experts will suggest maintaining a credit utilization ratio of less than 30 percent for each debt, while others suggest a 10 percent ratio is better. In any case, keeping it low is a good idea.
Fair Isaac does suggest carrying a balance might help scores. From the “Amounts Owed” page mentioned above:
In some cases, having a very small balance without missing a payment shows that you have managed credit responsibly, and may be slightly better than carrying no balance at all
But since they use words like “very small balance” and “slightly better,” we can infer you won’t gain much from carrying a balance. Since carrying a balance means paying interest as well as negatively impacting your utilization ratio, there’s really no reason to do so.
There are other, smaller factors determining FICO scores. The length of your credit history is important, which is why most credit card experts will tell you to keep your credit card accounts open as long as you can, even after they’ve been paid off and you’ve moved on to newer, better cards.
Hard pulls of your profile can affect your score negatively, which is why you should:
- Only apply for credit cards you’re reasonably sure you can get approved for.
- Keep the number of credit applications on your profile to a minimum.
To sum up
Mike, carrying a balance isn’t a sound strategy to improve your credit score. That said, it’s important to use your credit card, limit the amount you charge on it, pay the bill off on time each month and keep those accounts open if you’re hoping to achieve an excellent score.
Father usually knows best, but in this case we’ll take the advice of Fair Isaac when it comes to debunking the popular myth that carrying a balance improves scores. In short, it doesn’t.