There’s both a popular and completely misleading myth that keeping a balance on your credit card (account) benefits you. The belief is that when you carry a balance on your accounts, it helps you improve your credit score and overall credit worthiness—it’s not true.
The only parties that benefit from you carrying a balance on your credit cards are the credit card providers themselves and the banks.
Leaving a balance on your card will only end up leading to more interest payments, where that money could have been otherwise used to your benefit.
Here are four important facts that you need to know:
1) Credit utilization rate can be misleading
The credit card reporting bureaus have somewhat contributed to this fallacy by posting a credit utilization rate on your credit score report. The way your credit utilization rate is presented can give the impression that the ideal way of managing your cards is to always keep a utilization rate at around 30%. Really, you should be aiming to keep this utilization ratio as low as you possibly can, meaning that aiming for 0% should be your goal.
Only paying the minimum balance or a portion of the total debt owed each month will do two things. First, it will just keep you in debt longer. Second, you’ll end up paying more over time in interest payments.
When you pay off your credit cards and other credit accounts in full, you’ll start to slowly see the upside that comes with not carrying the balance. Your credit score will start to climb. You’ll have more cash available to use for things like building your emergency fund, starting a sinking fund, and even building your retirement income.
2) Credit card interest accrues daily
The average interest rate on a new credit card is somewhere around 17.5 to 18.5% APR (annual percentage rate).
Existing accounts average somewhere around 15.09% APR. With this number, most people are under the assumption that a $100 balance carried will mean $15.09 per year in interest. While it’s easy to see the math this way, there’s one thing that gets in the way of that; compounded daily interest.
The same way compound interest works in our favor, it also does so against us when it comes to credit.
To get a better sense of how this impacts your finances, let’s take a look at a quick example. Let’s assume you have a $203 balance carried over with an interest rate of 18%. The first day of interest will be $36.50 divided by 365. That comes to 10 cents for the day ($203 x 0.18 / 365).
The next day, interest is added and the new balance becomes $203.10, plus any additional purchases and minus any new credits or payments. This process occurs each day until the end of the cardholder’s monthly statement cycle.
Sure, this might not seem like much, but this phenomenon happens every single day, and with thousands of dollars. You can thank compounded interest for that.
3) Keeping a balance lowers your purchase power
That 30% balance you’re leaving on your credit accounts might seem insignificant, but it isn’t. How much purchase power does that thirty percent represent?
Every card has a credit limit. By letting a balance carry over, you’re essentially lowering yours. Many of us can trick ourselves into thinking that’s a good thing, yet it’s really not. Having lower card limits won’t curb poor spending habits.
On the other side, if you actively pay off your balance in full each month, your credit card company will eventually raise your credit limit. If you’re maxed out all the time, they may choose to lower your credit limit, which can significantly decrease your purchase power.
While you might not want a credit account with a limit exceeding $10,000 in some cases, you also certainly wouldn’t want one where you are limited to only $500 or $1,000 limits. This can make purchasing larger items such as appliances and home furniture difficult.
4) Multiple credit cards can make this a larger problem
Somewhere around 7 in 10 people have at least one credit card, and the average amount of credit cards carried by consumers is three.
While having more than one card isn’t necessarily a problem, it certainly becomes a problem when you start managing three or more cards. Take everything explained above and multiply it by the number of cards you have. Just like the interest alone on your cards, everything else compounds.
When you’re just starting out and new to building your credit, you shouldn’t be carrying more than one card. The same applies if you’re in a position where you are rebuilding your credit.
If you are carrying two or more cards, are you carrying balances on all of them? If so, that means each of those cards is accruing interest daily. Not only can those interest costs add up, it can put you in a dangerous financial situation if you were to get sick, lose your job, or continue to fall short of making your payments in full.
There’s no one-size-fits-all recommendation for how many credit cards you should have. However, a good rule of thumb is to carry one or two credit cards, because you can take advantage of credit card benefits without having too many cards to manage.
The key is to take it slow and to follow smart spending habits no matter how many credit cards you have.
Paying off your balance
By now, it should be pretty clear that paying off your credit card either in full, if you can, or at least more than the minimum amount is the way to go.
While it might not necessarily be easy depending on your situation, it will heavily benefit you in the long run.
If you’ve currently been carrying a balance over every month, stop right now and change that habit. It’s time to ditch carrying the balance over, and instead focus on finding ways to eliminate and reduce your balance entirely.