While there’s no doubt the most practical part of ourselves prefers debt-free living, there’s a fair amount of conflicting messages on the subject, specifically as it relates to your credit score. On the one hand, you need activity on your credit reports to prove you are a responsible user of credit. On the other hand, carrying too much debt can actually hurt your credit score. The truth is, the do’s and don’ts of debt-free living lie somewhere in the middle.
Do Use Your Credit Cards. Simply having a credit card in no way exhibits to lenders that you are a responsible user of credit. The key is to actually use the credit account, then demonstrate behavior that signals to lenders you know how to handle it.
Do Aim For a Zero Balance on Your Credit Cards. The only way of ensuring a zero balance — on a card that you actually use — is to only charge as much as you have the cash to back it up (i.e., pay it off by the end of the month). Otherwise, you could be stuck carrying a balance, only able to make your minimum payment. While the credit card companies certainly won’t mind making money off your finance charges every month, your pocketbook will.
Do Carry Debt That Makes Good Sense. Credit card debt does not fall into this category as 1) credit card debt is not an asset that grows in value over time and 2) credit card debt does not have the potential to generate future income. Debt that does meet one of these criteria includes mortgages, home equity loans, student loans, and even auto loans, provided a vehicle is necessary to get you to and from work.
Do Keep Your Credit Utilization Ratio as Low as Possible. Try not to use more than 30 percent of your credit at any one time, as the more of your available credit you use, the more you are seen as a credit risk which will be reflected in your credit score. If you have mortgages, home equity loans, auto loans and/or student loans, this makes a zero balance on your credit cards all the more important.
Don’t Avoid Using Credit Cards. While a good credit score is not dependent on credit cards, they can be a great way of exhibiting the kind of credit activity lenders equate with responsible credit use. Provided you only use them occasionally and pay off the balance before your statement date, you can avoid finance charges and maintain a history of zero balance, while still exhibiting a good amount of activity on the account.
Don’t Confuse Credit Card Statement Dates With Due Dates. If you pay your bill in full before the lender generates your statement, you will avoid finance charges, plus your account will show a zero balance. If you wait and pay on the due date, or any time after the statement is generated, you’ll not only be carrying a balance forward (increasing your credit utilization ratio), but you’ll also be paying finance charges to boot.
Don’t Believe That Paying Finance Charges Helps Your Credit Score. In fact, whether or not you pay finance charges is in no way reflected on your credit reports or in your credit score. The only thing that’s noted is the activity itself. In other words, your credit score will benefit just as much from you immediately paying off a credit card charge (even the very same day) as it would from waiting until your due date.
Don’t Confuse Debit and Prepaid Credit Cards With Other Types of Secured Credit Cards That Report To Credit Bureaus. We often advise those who are rebuilding their credit to consider secured cards if and when they cannot qualify for an unsecured account. However, this is only a helpful decision if the creditor offering the secured card will report your activity to the credit bureaus. This is not the case for debit cards, or for many prepaid cards. This means you should compare cards carefully before applying so that you’re sure to get one that’s actually going to help improve your credit score.
Don’t Take Out Payday Loans or Title Loans. When you’re in a pinch, the dreaded payday and title loans can start to look good. Keep your head, though, at all cost. While, ideally, you would be in and out with one clean swoop, paying off your loan in full under the initial contract terms, this rarely happens. In fact, the average payday borrower takes out 11 loans in one year. This spells disaster, as the annual interest rate can be as high as 300 percent. It’s easy and necessary to tell yourself that you’ll be the exception, but beware of how easy these lenders make it to roll those loans over and keep you indebted indefinitely. The very loans you needed to make ends meet actually spread you even thinner, making it tougher to pay on other debts, a direct threat to your credit score, not to mention your general quality of living.