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Writing about credit scores and credit cards, I come across bad or ill-informed advice all the time. Two common tips in particular irk me.
- Paying in full is good for your credit score.
- Keeping a small balance on a credit card improves your credit score.
- Source: FICO
There are numerous scoring models in existence, but the most popular one, known as FICO, doesn't reward or deduct based on whether you carried a balance. In fact, there is no notation on the credit report as to how much of the bill the borrower paid.
While paying a credit card balance off every month is financially smart, payment in full isn't a factor that boosts the score. That's because the scoring model only sees the monthly balances reported by lenders. In the case of credit cards, the reported balance is usually going to be the outstanding balance from the last statement. People who spend heavily on their credit cards to rack up rewards points could lower their score by doing so, if their monthly reported balances are high in relation to the credit limit. A high balance-to-limit ratio, or utilization, on your credit cards can harm your score.
You can probably see why the second tip doesn't tell the whole story either. While small reported balances are good for the score, you don't get points for paying interest. Pay in full whenever possible to avoid finance charges.
The ideal strategy is to charge small amounts on credit cards and then pay in full every month. A small reported balance is slightly better than a zero balance in terms of the score. This graph from Credit Karma, a site that provides free TransRisk credit scores from TransUnion, illustrates the relationship between utilization on credit cards and credit scores.
