Is it better to pay off your credit card or keep a balance?

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In my perfect world, as I see it, no one would ever carry a balance on a credit card. Carrying balances usually means you are paying interest on your purchases, so whatever you bought ends up costing you more than need be.

Even in the case of low or no interest promotions, carrying debt always represents a risk, whether you think so or not. Depending on how high your balances are in relation to your credit limit, you may also run the risk of damaging your credit score.

But this is not a perfect world, and my idea of a perfect world is not everyone’s, which means it’s a little more complicated. So, let’s dive in and see what we can discover.

Does keeping a balance help your credit score?

Credit utilization, or the amount of your available credit you have used, is an important factor in your credit score. Second only to payment history, it counts for about 30 percent of your total FICO score. VantageScore uses a weighted scale and calls this part “extremely influential.”

Here’s a simple illustration: you have a credit card with a $500 limit and you use $250 to make a purchase. Your credit utilization ratio is 50 percent. This is going to be bad for your credit score. Conventional wisdom says you would need to use no more than 30 percent, or $150, to keep from losing points in your credit score. I personally believe that the percentage to shoot for is 25 percent or less, or $125, in this example. Keep in mind that this is the total amount you should spend in one billing cycle on this card.

Chances are you have at least one more credit card, so we have to take that into account as well. Let’s say the second card has a $1,500 limit and you have used $400. This puts you between the 25 percent and 30 percent utilization ratio on this card. This is important because while each card will be counted separately, they will also be combined to come up with a total.

Overall in this example, the utilization rate is 26.25 percent (1500 + 500 = 2,000 total credit; 125 + 400 = 525 total used; 525/2,000 = 26.25). So you are a little higher than I would recommend, but your score should not be negatively impacted. It also probably won’t go up much, either.

At 30 percent utilization, you will effectively maintain the status quo on your credit score. Moving down to 25 percent could result in an increase in your score. The lower you can go, the better it will be for your score, assuming all of the other factors that go into your score are in good shape.

So how low are we talking here? Those who enjoy the best credit scores typically have utilization factors in the single digits. But remember that they are also doing all of the other things right—they are paying their bills on time, as agreed; watching their utilization, as we have illustrated; not closing old accounts to maintain their credit history; have a good mix of both revolving and installment accounts; and only open new accounts as needed.

Is it better to pay in full or carry a small balance?

Some high credit score achievers may carry a small balance (think single percentage points) in order to demonstrate that they are using the credit they have been given. There is a school of thought that says this is necessary to show they can and do handle their credit in a responsible way.

If your accounts are always at zero, it may look like you are not doing that. Here’s why: A card that is unused gives the scoring models little or nothing to work with in assessing risk. Some balance, any balance, allows the models to have something to crunch, resulting in a greater likelihood of your score improving. The scoring elves have found that cards reporting no balance have a slightly higher risk factor than a card carrying a very small balance.

The key here is to know when your credit card issuer reports your account information to the credit bureaus. In many cases, that will be at the end of your billing cycle. Your balance on that day will be what’s reported to the bureaus, and it will be factored into your credit utilization. So, in theory, you could keep a small balance on that date and then pay it off the next day to show some account activity and avoid interest charges.

Hitting 1 percent seems to be the holy grail here. However, I am not a fan of chasing the “perfect” score and trying to get to 1 percent may be a lot more trouble than it will ultimately be worth.

When does carrying a balance hurt your score?

As we have seen above, if you go beyond 30 percent of your available credit, your score is likely to suffer at least some damage. This can be reduced if you are able to get those balances down below that threshold. And you may begin to see improvement at 25 percent, which will increase the lower you can go.

I mentioned earlier that one reason not to carry a balance is that you are likely to incur interest charges. But there are credit cards that offer a low or even 0 percent introductory interest rate. These are most often for a specific period of time, typically 12-15 months. Carrying a balance on a card like this may make good financial sense, but it also carries with it increased risk. For example, as long as life is treating you well, there’s no problem.  If you lose your job, get sick or have any one of a number of reversals of fortune – that can be a big problem.

Using a low or zero interest card for a large purchase allows you to spread out the cost over a period of time without incurring hefty interest charges. Just be sure you know the terms (how long you have before interest may kick in) and stick to your payment plan. You’ll be on the hook for interest charges if you miss a payment or if you don’t pay the balance in full before the introductory period ends.

Also, remember that the utilization factor will still be in place, so you should be prepared for what that might mean for your score. It could still be worth it to you, depending on your situation. I would say you need to weigh your choices carefully here, but do what is best for you and your family.

How paying in full helps your finances

Paying your balances in full every month demonstrates that you are living fully within your means. In other words, you are not using credit cards to extend your income, but as a way to spend the income you already have. This is the best sign of overall financial health.

The bottom line

Reporting a balance on your cards of more than about 30 percent of its maximum credit line will hurt your score and carries additional risks. The lower your balances, the better your score, and a very low balance will keep your financial risks low. But the best way to maintain a high credit score is to pay your balances in full on time, every time.

How you choose to use the credit that is given to you is always up to you and your own personal situation. But knowing how your choices affect both your credit score and your overall financial health is smart.

Good luck!

Have a credit score question for Steve? Drop him a line at the Ask Bankrate Experts page.