Most people know that paying off your credit cards completely will improve your credit score. But they also think that carrying a small balance on your accounts is also very beneficial. This is a myth. In fact, carrying a small balance will not help improve your credit score.
Purposely leaving a small balance on your credit card will just cost you money in wasted interest charges.
What is Credit Utilization?
The reason the myth arose that carrying a small balance will increase your credit score came about is because your credit utilization makes up 30% of your credit score.
Your credit utilization is a ratio reflecting the sum of your outstanding balances divided by the sum of your total credit available (including car loans, mortgages, credit cards, etc.).
Although having a credit card balance isn’t at all necessary for a good credit score, the monthly balance that your creditors report to the three credit bureaus plays a large role. These reported balances are weighed next to your available credit, creating a debt-to-credit limit-ratio, or utiilization ratio, that accounts for a full third of your FICO score.
This caused people to theorize that showing you can responsibly handle your credit (i.e., utilize it well) is to show you actually make use of it. So people recommended that you carry a small balance on your cards to show you actually utilized them. They reasoned this would help increase your credit score.
The truth, however, is that you can pay your cards off in full every month and still show that you are utilizing credit. This is because, as long as you regularly use your cards, there will be some amount outstanding that is not yet due. And this amount will be reported on your credit report.
So you get the benefit of utilizing your credit, but not the hassle of paying heft credit card interest charges. I call that a win-win.
The truth is that you are always utilizing some credit from your cards, even if you pay your balance in full every month.
What If I Max Out My Cards?
Another thing to realize about how your credit card use is reported is to understand the idea of reported balances.
For example, people that charge their card limit completely each month but pay in full aren’t likely to have a good credit utilization on their report because each month their creditor will report as if the card has been maxed out.
My advice here is to to aim for no more than 30% utilization of any one credit card and no more than 30% of your total available credit. If possible, get your total utilization ratio down to 10% or less.
Your actual account balance is not always what gets reported to credit bureaus. Most credit card companies report your statement balance, which means your credit can be hurt even if you pay off your bill in full each month. Because you are showing high credit utilization.
Instead, make a goal of not charging more than 30% of your credit limit in any given month.
What Else Can I Do to Help My Credit Score?
It’s also important to realize that the best thing to do for your credit score is to pay your bills on time, avoid accumulating debt, and wait.
Still, this method is great for people that are looking for every point that can get to qualify for a low mortgage or loan rate. In general, the best thing to do is to always keep your card balances below 30% of the limit and make on-time payments for a dazzling credit score that will net you the best interest rates available.
One of the best resources for anyone trying to increase their FICO score is MyFICO.com, particularly the Forums. The FICO boards have helpful posts for understanding the FICO scoring method, as well as ways to qualify for credit and rebuild problem credit histories. You can also sign up for a free trial of of the FICO Score & Credit Report monitoring, as well as Score Watch and Suze Orman’s FICO Kit.