Paying off your credit card can quickly improve your credit score, but it has another benefit that might feel even more important
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- Your credit score is calculated using a number of factors including your credit card balance, also known as your revolving debt.
- Paying off that balance is often the fastest way to improve your credit score.
- While a quick boost to your credit score is one benefit of paying your balance, another might feel even more impactful: You'll stop paying interest, and save significant money in the long term.
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Back in high school, your grade point average, or GPA, was the main metric of your academic success.You could take every test, quiz, homework assignment, and summarize it with a number between 0.0 for a failing average to a 4.0 for a perfect history of all "A" grades.
As an adult, there is another important number you need to think about that summarizes your history with credit and borrowing: your credit score.
If you use credit cards regularly, the best strategy is to pay off your entire balance in full each month by the due date. If you carry a balance, it can drag down your credit score while paying interest for the privilege. Let's take a look at how credit card balances impact your credit score and the best method to get the best credit score possible.
The factors in your credit score
Your credit score is composed of a handful of major factors. The biggest input is your on-time payment history, which makes up 35% of your score. The second-biggest factor is your current credit balances, which make up 30% of your score.
These two parts of the credit score formula make up 65% of your credit, so if you are going to focus on any specific areas, these are the places to look. Your on-time payment history tracks payments for open accounts. Missed payments stay on your credit report for seven years, so it is very important to always pay on time, even if you can only pay the minimum.
The remaining parts of your credit score are made up of your average account age (15%), new credit (10%), and your mix of credit accounts (10%).
How balances are reported on your credit reportIf you have an open credit card, line of credit, or other revolving credit accounts, the lender likely reports your credit balances to one or more of the three major credit reporting bureaus every month. This may fall somewhere near your monthly payment due date, but there is no rule that the two will fall anywhere near each other on the calendar.
Therefore, the balance on your credit report is merely from a snapshot in time. Whatever your balance was on that account the day it was reported will show up on your credit report the next time it updates. The timing of this balance can have a significant effect on your credit, particularly if you have low limits in relation to those balances.
The balance portion of your credit score is calculated across all open credit accounts. For example, if you have four credit cards with a $2,500 limit each, your total limit is $10,000. Your credit score is based on the total balances of those accounts divided by your total limit. Many credit experts say that you should stay below 20%-30% of your total limit to have the best credit score, but that may be a bit misleading. The best balance you can have for your credit score is $0.
If you use your credit cards regularly, your score will probably ebb and flow a bit with your spending and payment habits. I recently had a large purchase on one credit card and my balance was reported shortly after. My credit score took a slight dip for one month, as my balances were higher than usual. After I paid it off the next month, my score jumped right back up to where it was before.
If you keep your balances at zero or as close to it as possible, you are doing the right things for your credit. Contrary to a popular myth, you don't have to carry a balance to build your credit.
Paying off your cards in full each month has more than one benefit
The perks of paying off your cards don't stop at your credit score. Your bank account wins in several ways from paying off your cards before the monthly due date. The biggest benefit: You don't have to pay any interest.
Credit card interest rates are often quite high, often reaching the 20% to 30% range. Paying just the minimum on your credit cards means you'll pay a lot more than the list price for a purchase. It can take years to pay off a credit card with that strategy.
If you currently carry credit card balances, the fastest way to improve your credit is usually to pay those balances off to $0. While it is easier said than done, it saves you on interest in the short and medium term and helps build your credit for the long term. If you can keep your credit card balances paid off, your finances will be in much better overall shape.If you are going to follow one Golden Rule for credit, it is this: Keep balances low and always pay on-time. If you can do those two things, you should be on track for a credit score in the 800-plus club. That can save you money, get you the best interest rates, and help you access the best credit products on the market today. That's what a great credit score is all about.
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