You already know massive amounts of debt could mean bad news for your finances.
Tens of thousands of dollars worth of student loan or credit card debt costs you in interest payments and eats up your monthly cash flow. Debt can prevent you from saving more or achieving other financial goals important to you.
Many Americans can speak to the stifling reality of carrying debt. The average household that carries a balance has $16,048 in credit card debt.
That doesn’t include other debts, like auto loans or debt from higher education.
Obviously, big balances and lots of debt hurt your financial life. And it can drag your credit score down, too.
But not everyone has five-figures worth of debt or a huge balance that they need to repay.
Perhaps you keep a small balance on your credit card. You may not even have debt if you pay that balance off every month before the end of the statement period.
Can this small balance hurt your credit score in the same way as a large balance? Let’s take a look at how credit scores work to answer this question.
How Credit Scores Work
Your credit score is a measure of how financially responsible and creditworthy you are. And you actually have more than one -- each credit reporting agency issues you a score. So does a company called FICO.
Other types of scores use different grading systems, but the one you want to focus on is the FICO credit score. In fact, 90% of lenders use FICO’s metric, so you may want to look at the same score they do.
FICO bases their formula that calculates credit scores on five main factors
FICO Credit Score Factors and Their Percentages
|FICO credit score factors||Percentage weight on credit score:||What it means:|
|Payment history||35%||Your track record when it comes to making (at least) the minimum payment by the due date.|
|Amounts owed||30%||How much of your borrowing potential is actually being used. Determined by dividing total debt by total credit limits.|
|Length of credit history||15%||The average age of your active credit lines. Longer histories tend to show responsibility with credit.|
|Credit mix||10%||The different types of active credit lines that you handle (e.g., mortgage, credit cards, students loans, etc.)|
|New credit||10%||The new lines of credit that you've requested. New credit applications tend to hurt you score temporarily. Learn more about FICO credit score|
Although they don’t disclose the exact formula they use, knowing what makes up a score can help you understand how your actions impact it -- whether you cause it to rise or fall.
For example, failing to make payments on your bills and balances will cause your score to drop over time. That’s because 35% of your score is determined by your payment history.
But always paying what you owe in full and on time can help you raise your score or maintain a good score over time.
What’s a Good Credit Score, Anyway (and Why Does It Matter)?
Credit scores exist on a range, with the very best being 850. Not many people achieve this perfect score -- and that’s okay.
Credit in the good to excellent range is what you need to get approved for most loans and lines of credit and access the best interest rates.
Excellent credit is anything above 750, and a credit score that falls between 700 and 750 is considered good.
Credit in the 650-700 range is fair or average, which is where the average person’s credit lies.
A score of 550 to 650 typically indicates poor credit, and anything below 550 is bad. Both poor and bad credit are subprime, and make it difficult to get approved for loans and lines of credit.
Keeping a good credit score matters because it’s what allows you flexibility when requesting financing.
With a better credit score, you qualify for better credit cards and loans. Better scores mean better interest rates.
This is where your credit can really cost you. If your credit score is lower, your interest rate will be higher, which could cost you a lot of money, especially if you’re looking at taking out a large loan like a mortgage.
The difference between getting a mortgage with a 4% interest rate and a 5% interest rate can mean tens of thousands of dollars owed in interest payments alone.
So it’s worth it to keep an eye on your credit score and maintain a good one. And that’s why asking if keeping a small balance hurts your score is a smart question.
The Impact of a Small Balance on Your Credit Score
Part of what makes up your credit score is something called “amounts owed.” This refers to your balances.
If you keep high balances on your cards and use up a lot of your available credit, this indicates that you may be stretching yourself too financially thin.
As a result, your credit score can drop because you seem less likely to be able to repay additional money you borrow or credit you use.
Whether that’s true or not is another story. Credit scores are based on these set factors and don’t necessarily take into account all the nuances involved in your specific situation.
FICO’s predictive analytics indicate that those with high balances present higher risks, which is why a big balance can drop your score.
Still, amounts owed makes up 30% of your score. If you want to maintain good credit, you need to play the game.
This means paying off what you owe and keeping low balances for the best credit scores. Ideally, you want to keep your balance as low as possible.
But that’s not always possible. So at the very least, aim to keep your credit utilization ratio to 30% or less.
This ratio indicates the relationship between how much credit you have available and how much you use.
If your credit limit is $500 and you keep a balance of $250, your credit utilization ratio is 50%. In this situation, it would be better to keep your balance to $150 or less to keep your credit score happy.
Keeping a small balance -- or whatever takes up 30% or less of your available credit -- should not hurt your score.
Keeping a larger balance can start negatively impacting the number. Failing to pay your balance and racking up debt will cause it to drop even further.
Keeping that small balance doesn’t help. It just doesn’t hurt your credit score. Don’t hold a balance for the purpose of improving your credit.
What You Can Do to Minimize Your Balance
If you keep a balance of 30% or higher, you could improve your score by lowering that amount.
Remember, even if you don’t carry debt, you could still show a balance on your credit report if you charge purchases to your credit card.
Let’s say you have a credit card with a $1,000 limit. Charging $900 to the card but paying it off before the bill is due and it starts accruing interest may seem like a fine idea.
After all, you don’t take on any debt. You made your payment on time and paid the entire balance, which should be good for your credit score.
But doing this could end up hurting your score, regardless of the fact that you paid off what you charged to the card. Balances are reported to credit bureaus at the end of every statement cycle for the purpose of calculating credit scores.
So if your credit card issuer reports your balance before you pay it off, that’s reflected in your credit score.
Making your payment on time also gets reported, but it may not be enough to offset the damage done by the high balance even though it wasn’t actually debt.
If you need to use up a lot of your available credit -- but can afford to make the charges and plan to pay off the entire balance -- consider making partial payments throughout the month. This will help lower your balance so that the full amount isn’t reported to the credit bureaus.
This means making a payment on your card more than once a month, but it’s worth the effort to reduce the balance that gets reported to get the best credit score possible.
You could also consider increasing your credit limit. By doing so, you can keep your balance the same -- but you’ll have more available credit, which reduces your credit utilization ratio.
Finally, you could simply spend less on your credit card in order to minimize your balance. While there are plenty of benefits to using credit, there are drawbacks, too.
It’s easy to forget a bill due date, which can trigger a late fee and cause damage to your credit score. It’s also easy to spend too much if your credit limit and your actual spending limit imposed by your budget don’t line up!
Charging less to your credit card and using cash or debit (or another payment processor, like PayPal, if you shop online) can help you minimize a credit balance.
A small balance won’t necessarily hurt your credit score if it takes up less than 30% of your available credit.
But anything more than that could start impacting the “amounts owed” factor that helps determine your score -- even if you pay that balance off and don’t carry debt.
So be mindful about how much you charge, and either make multiple payments throughout the month to reduce the balance reported to the credit bureaus or reduce the amount you put on your card in the first place.
This will help you maintain a good credit score, which benefits your financial life as a whole.