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Credit Card Basics: Credit Scores & Compound Interest

Credit Card Basics: Credit Score & Compound Interest
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Cody

Creator at Fly to FI
Cody is a 22-year-old entrepreneur, life optimizer, and creator of Fly to FI. He is a personal finance junkie who constantly tracks his net worth with Personal Capital.

In his spare time, he enjoys exploring the globe for FREE using a technique called travel hacking!
Cody
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I felt obligated to write this post because I know too many people who don’t understand how credit cards work. My aim is to clear up any confusion regarding credit cards, credit scores, and credit in general. Misunderstanding and misusing credit can have detrimental impacts on your financial future. Do you know anyone who could benefit from this article? Please share!

How Credit Card Companies Make Money

The ONLY WAY that credit card companies can make money off of you is if you carry a monthly balance (besides annual fees, if applicable).

“Carrying a balance” = Not paying off your credit card statement in full. 

If you leave an unpaid balance on your credit card, that balance is hit with an interest charge (discussed later). So why doesn’t everyone just pay their credit statements on time and in full every month to avoid the interest?

Good question. That’s why I wrote this article.

You shouldn’t ever leave a balance on your credit card unless you’re in an extremely dire situation. If you can afford it, pay it off! If not, maybe you shouldn’t have spent so much on the card in the first place.

The Biggest Misconception About Credit Scores

The most common misconception I hear is that people purposely carry a balance on their credit card every month in order to “improve their credit score”. This is flat out wrong! Never just make the minimum payment.

Your credit score is determined by five unique factors: Payment History (35%), Utilization (30%), Length of Credit History (15%), Recent Activity (10%), and Credit Mix (10%).

Credit Score Factors - Fly to FI

Payment History (35%)

This is the most important factor in calculating your credit score. If you pay your credit card statements on time every month, this score should be perfect. However, if you miss even ONE payment, the credit agencies will ruthlessly ding your score.

Factors affecting the severity of your score reduction are size of payment, lateness of payment, and historical frequency of missed payments. The moral of the story is don’t make late payments!

Pro Tip: If you tend to be forgetful, the best way to combat this is to automate your payments.

Utilization (30%)

This number represents what percentage of your credit limit you’re using each month.

For example, if my credit limit was $5,000 and I had $2,500 outstanding on my credit card, my utilization rate would be 50%.

Ideally, you want your utilization rate to be between 0% and 10%. Many experts will say that under 30% is okay, but under 10% is certainly preferable. Please note that a 0% utilization rate will not increase your credit score in this category.

Pro Tip: Credit Agencies check your utilization rate on the same day every month. If you know which day that is, you can pay off some of (not all) your balance early to get under a 10% utilization rate, then let auto-pay take care of whatever is left.

Length of Credit History (15%)

This credit score factor is especially difficult to score high in for people in their early twenties or younger. Length of credit history is calculated by taking the average of all your credit accounts and determining a “credit age”.

If you have some old credit cards that you don’t use anymore and that don’t have an annual fee, keep them! These old cards will help to skew your length of credit history (the long way).

Pro Tip: START EARLY. Your credit clock starts at age 18. Try to get approved for a secured credit card or have your parents add you as an authorized user to establish your first credit account.

Recent Activity (10%)

Your recent activity is based on your credit history over the past six months. This includes number of new accounts, date of most recent account opening, and quantity of recent credit requests.

Pro Tip: Don’t apply for a ton of new credit accounts in a short period of time.

Credit Mix (10%)

The last credit score factor is determined by the number of different credit accounts you hold. These accounts include mortgages, credit cards, auto loans, and other installment loans. A more diversified credit mix can help to boost your credit score.

Pro Tip: Let credit mix happen naturally. Don’t go out and apply for a mortgage or auto loan just to increase your diversification.

There you have it. Not once did “Carry a Balance” appear in the formula to determine our credit score! This misconception really grinds my gears. Maybe the credit card companies have somehow made it seem like you need to have a monthly balance on your credit card in order to build credit… I really don’t know.

The Dark Side of Compound Interest

Compound interest works wonders for your investments. However, this phenomenon inflicts an equally negative blow to your outstanding credit. Let’s take a look at a couple scenarios.

Credit Card Chris

Chris buys a $5,000 hot tub with his new 15% APY* credit card. The following month, his statement balance is $5,000. He makes minimum payments of $150 every month. It takes Chris 145 months or 12 years to pay off this credit card. In total, Chris has paid $8227.52 for his hot tub. This includes $5,000 in principal (his initial balance) and $3227.52 in interest charges.

These interest charges are almost criminal. Chris ends up paying 164.5% of the hot tub’s purchase price. This only gets worse as the amount of credit increases.

Auto Loan Amanda

Amanda buys a brand new car for $50,000 using a 5% APY*, 5-year auto loan. She makes minimum payments of $944 every month. After five years, Amanda has paid $56,614 for her car! This includes $50,000 in principal (her initial balance) and $6,614 in interest charges.

I hope that these examples help to show you the dark side of credit. If you take away one sentence from this whole article, it should be:

ALWAYS PAY YOUR CREDIT CARD STATEMENTS IN FULL AND ON TIME EVERY SINGLE MONTH.

*APY = Annual Percentage Yield = How much interest your credit accumulates over a given year as a % of balance outstanding.

Do you feel like you have a better understanding of how credit cards, credit scores, and credit in general work? Please share in the comments below!


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Note: I am not a financial advisor or fiduciary. All of the information presented in this article reflects my opinion. I am not liable for any financial losses incurred related to this content. My content is always written with the readers’ best interests in mind. I believe that my content is helpful and well-researched, but it is not professional financial advice. For more information, read our Privacy Policy.

8 thoughts on “Credit Card Basics: Credit Scores & Compound Interest

  1. You can sign up at creditkarma.com to check your credit score anytime you want. it also breaks down the categories above for you

    1. Thanks for sharing, Ruth! That’s defintiely a tool I use quite often. And checking your score through Credit Karma or Credit Sesame doesn’t count as an inquiry on your account.

  2. Thanks for the primer Cody! The biggest mistake people make is carrying balances on their card…. That’s where the dark side of compound interest really does a number on us.

    Good stuff man, cheers!

    1. Thanks for reading TJ! I have so many friends and family members who believe that carrying a balance is needed to build credit… it’s simply not true! Glad you agree and I hope you can share this message!

  3. This needs to be taught in every high school in the country! I never heard anything having to do with credit or compound interest in my school career, but I did learn about the Magna Carta and how to do long division by hand.

    1. Lol! I totally agree with you Captain DIY. I’m actually doing a few talks and Skype calls at high school to teach basic financial literacy. I’ll definitely use this article as a guide. Thanks for reading!

  4. Being 20 years old, tons of my friends have absolutely no idea about how credit really works. My parents would even tell me to avoid credit cards completely! It’s crazy how misunderstood this topic is. A1 article!

    1. Thanks Lauren! Glad you enjoyed the article. I think that even if you were 40 years old, many of your friends STILL might not understand how credit scores and credit works in general. Hope you can point them to this article for more information!

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