Do You Have to Carry a Balance and Pay Interest to Build Credit?

It’s a common belief:

A way to improve your credit is to carry a small balance from month to month.

Creditors like to see that people take out loans and pay interest on them, so they give people who pay interest a better score.

If you think about it that way, it makes a lot of sense.

Luckily...

This isn’t true.

You don’t have to carry a balance from month to month to build your credit score.

In fact, carrying a balance can hurt your score if the balance is too large. In effect, you’ll be paying interest for no benefit at all.

Learn how credit reporting and scoring really works to the common myth that carrying a balance is good for your score.

You Never Need to Pay Interest to Build Credit

Though credit card issuers certainly want you to carry a balance, there is no need to carry a balance to improve your score.

This myth favors lenders who want to prey on people without much knowledge of the financial system.

By convincing people that carrying a balance is good, they are able to earn more in interest.

Data report to credit bureaus

Each month after your payment due date, you creditor makes a report to the credit bureaus.

These credit bureaus -- Experian, Equifax, and TransUnion -- are independent companies.

They track information about American consumers and sell that information to lenders.

The fact is:

The credit bureaus don’t record whether you paid interest or not.

Your creditors report the following information to the credit bureaus:

  • Was your payment on-time?
  • Your credit limit
  • Your statement balance

The amount of interest you pay is never mentioned. The most important piece of information is whether your payment was on-time.

You never need to pay interest to improve your credit score. It is possible to have a fantastic credit score without paying a cent in interest.

If a lender tells you otherwise, they are misinformed or trying to trick you.

How it Really Works

As was mentioned, your creditor will report your card’s statement balance to the credit bureaus.

This is the balance of the card on the day the statement ended.

Even if you paid off the balance in full the next day, the full statement balance will be reported. This is enough to show the credit bureaus that there is activity on the card.

Consider this example.

Your credit card statement starts on the 1st and ends on the 30th. Over the course of the month, you spend $450 on your credit card. On the 30th, your statement closes with your card’s balance at $450.

On the payment due date, you pay $450. Because you paid the statement balance in full, you won’t incur any interest charges.

Your creditor sends a report to the credit bureaus, saying that you made an on-time payment and that your statement balance was $450. The $450 balance is reported even though you completely paid it off.

Showing some activity on your cards, by allowing your statement to close with a balance, is a good thing.

It shows the credit bureaus that you’re actually using the cards.

What you want to avoid is showing too large a balance. If you’re maxing out your credit card limits, that looks bad to lenders. It makes it seem like your in a bad situation financially and might not be able to pay off your debts.

If you’re going to put a lot of charges on your credit card, you can make multiple payments during your statement period.

For example, if you charge $1,000 to your card and make a $500 payment before the statement closes, the statement balance will only be $500.

A good rule of thumb:

Keep your credit utilization ratio, the ratio of your statement balance to your credit limit, at or below 30%. Make payments during the month to maintain this ratio.

Remember, showing a statement balance is not a bad thing for your credit.

Carrying a balance offers no benefit. Pay your credit card in full every single month.

How Credit Scores Work

Your credit score is a numerical representation of how trustworthy you are as a borrower.

Scores range from a high of 850 to a low of 300.

Higher scores indicate that lending money to you is less risky.

Lower scores show that you have a higher chance of missing payments.

Your credit score has a big impact on your financial life.

It affects the loans and credit cards you are eligible for. You might have trouble qualifying for a loan at all if your score is bad enough.

Your credit score also impacts the interest rates you’ll pay on the loans you qualify for. Higher rates mean higher payments and higher total costs for loans.

Having a bad credit score makes borrowing more expensive.

Your credit score is calculated from five aspects of your financial life:

  • Payment history
  • Amount owed
  • Length of credit history
  • New credit
  • Types of credit used

Payment history

Your payment history is, by far, the most important part of your credit score.

Lenders mostly care about whether they will get back the money that they loan to you. Showing that you will consistently make your payments gives lenders confidence.

The fact is:

Missing even a single payment can have a huge effect on your credit score.

Ideally, you should be paying off your balances in full each month.

If that isn’t possible, make absolutely certain to at least make the minimum payment. Missing a payment will have long-lasting, and expensive, effects.

After your payment history, the amount you owe is the next important part of your credit score. The more debt you have, the worse your credit score will be.

Your amount owed can be broken down into two subcategories: your credit utilization ratio and the total amount you owe.

Amounts owed

Your credit utilization ratio can be calculated by dividing your total debt by your total credit limits.

The lower this ratio is, the better it is for your score.

Why?

Maxing out your credit limits is risky behavior in the eyes of lenders. It appears you're desperate to borrow to survive.

Average account age

The length of your credit history also impacts your score in two ways.

First is the actual length of your credit history. The longer you’ve been dealing with credit, the better you will be at it. That means a longer history improves your score.

Lenders also look at the average age of your loan accounts.

Jumping from loan to loan or credit card to credit card doesn’t look good.

Lenders want to form long-term lending relationships. That means that you’ll have a higher credit score if you’ve kept your credit cards and loans for a longer time.

New credit inquiries

Relatedly, new credit applications impact your credit negatively.

Each time you apply for a loan, the lender will request a copy of your credit report from one or more credit bureaus.

The credit bureaus take note of each time you apply for a loan. Each new application reduces your score by a few points.

After two years, the impact of loan applications falls off your report.

Applying for a lot of loans in a short time is a sign of risk, so lenders want to see people with relatively few applications in the past couple of years.

Credit types

Finally, lenders want to know that you are experienced with credit when they lend to you.

The more experience you have with handling different types of loans, the better equipped you will be to handle new loans in the future.

The more different types of credit you have on your report: mortgages, auto loans, credit cards, student loans, and so on, the better it will be for your score.

The impact of this is relatively low, so don’t take on loans you don’t need, but it’s good to know that it can help.

Don’t Overthink It

All in all, building your credit isn’t that hard. Take on debt when you need to, and make your payments every month.

Don’t borrow money unless you have to, and try to avoid paying interest whenever possible.

So long as you practice good financial habits, your credit score will improve.

Conclusion

It’s a common myth that you have to carry a balance and pay interest to build your credit.

In truth:

Carrying a balance will, at best, so nothing to your score. At worst it will make your score worse.

All you’ll be doing is paying extra for interest. Avoid paying interest and carrying a balance whenever you can.

Your credit will improve naturally if you practice good financial habits.

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