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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%).
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.
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 of 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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