It’s a widespread myth that you have to carry a credit card balance to build a good credit score. In reality, the opposite is true. Carrying big balances on your credit card could actually hurt your credit score.
How Credit Scores Work
Credit scores are calculated based on five key factors and some carry more weight than others. Payment history is 35% of your credit score, amount of debt is 30%, age of credit history is 15%, and mix of credit and recent inquiries are 10% each. Your credit card balances are factored into the “amount of debt” category, the one that’s 30% of your credit score.
The credit score calculation considers the amount of your credit card balances in relation to your credit limit. This ratio is known as your credit utilization. Your credit utilization responds to your credit card balances and credit limit. When your balances go up, so does your credit utilization. An increased in your credit utilization would cause a subsequent drop in your credit score.
The Ideal Credit Card Balance
To build a good credit score, you shouldn’t charge more than 10% to 30% of your credit limit. That means charging no more than $300 on a credit card with a $1,000 credit limit. Ideally, you would pay your balance in full every month to eliminate the possibility of racking up credit card debt. So, you should also avoid charging more than you can afford to pay off in a single month. Keep in mind, that amount could be less than 30% of your credit limit.
You’re gambling with your credit score if you charge a higher balance than what’s recommended and pay it off when the bill comes. Your credit score is based on the credit card balance that’s listed on your credit report, which might not reflect your balance today.
Many creditors only report your credit history once a month and your creditor might report your credit card details on the day your balance is highest. When your credit score is calculated, it’s based on that high credit card balance instead of the balance after your balance is paid.
How Loans Fit in the Picture
Credit cards aren’t the only accounts that boost your credit score. Installment loans are another major type that affects your credit. Though credit cards are given more weight, loans balances are also factored into the “level of debt” portion of your credit score. Credit scores look at the current loan balance compared to the original loan amount. You can also build a good credit score by reducing your loan balances.
Having loans as well as credit cards on your credit report can help raise your credit score. It shows you have experience with different types of credit and boosts your score in the “mix of credit” area.
If you don’t have a credit card or a loan and you’ve never had either, you probably don’t have a credit score. You’ll have to get one or the other to get started building your credit history.