Scoring formula quirk rewards you for having tiny balance
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Dear Speaking of Credit,
Do I keep my credit card balance zero or keep some on there to increase my credit score? – Monica
Your question is a good one, as it touches on some lesser known and often contradictory calculations within the “amounts owed” credit scoring category that makes up 30 percent of your score.
Are you actively using credit?
Research has shown that a consumer who has paid on time in the past and uses credit frequently, while carrying no more than a small amount of debt, is likely to continue paying as agreed without fail. Yet, someone whose low debt is the result of having not used credit recently represents a slightly higher risk and greater likelihood of future payment problems.
For this reason, showing that you’ve used credit recently can be essential to maximizing your score, despite the dilemma that credit reports used in credit scoring don’t specifically provide this information. That leaves the scoring formula to use credit utilization (balance/credit limit) percentages as one way to show recent card activity, or nonactivity, along with how much available credit has been used.
The way this works is that as long as you have at least one card with a balance of any amount, you’re considered a recently active credit user. But if all of the balances on your credit report show $0, the assumption is that you have not used credit recently. The result can be a score slightly lower than if you have at least one small balance.
Unfortunately, using utilization to indicate activity or inactivity ignores some other common reasons for all cards showing $0 balances, such as:
- You may simply have refrained from charging during the past month, though you’ve been using credit responsibly for many years.
- You may use many cards frequently each month and pay all charges before their closing dates.
So, going along with this often less-than-accurate attempt at measuring recent credit usage, showing activity via a small balance is a good way to boost your score by a few points.
How much do you owe?
It may not come as a surprise that credit utilization heavily impacts your score, since it reflects your ability to effectively manage the credit that’s been made available to you. And as you’re no doubt aware, the lower this percentage, the higher the score. But do you know that this is not always true once the percentage reaches zero?
Credit utilization reflecting the lowest percentages above 0 — 1-to-5 percent is best — will add more points to your score than when the combined utilization is at zero percent, the result of all card statements reporting $0 balances.
Why doesn’t the lowest possible utilization percentage of zero lead to a higher score in this situation? This is where the scoring formula essentially abandons the idea of lower debt leading to lower risk to measure recent credit activity. In effect, providing more points for a small balance than a $0 balance is the score’s way of rewarding a consumer for recent credit activity.
Are you juggling too many card balances?
Should all of this talk of small balances being good for your score mean you should carry balances on as many cards as possible? This being credit scoring, it’s never that simple.
While you now know that you don’t want zero percent utilization for all cards, you should also know that the scoring formula doesn’t want you to have too many cards with balances either. Both can be signs of higher credit risk that can lead to lower scores.
How many cards with balances should you have? While FICO will never tell you how many cards with balances to carry, they have provided us with some insight into the credit profiles of “high achievers,” people with scores higher than 785. On average, these high scorers have balances on four cards or loans.
What to do then?
Based on what we now know, you should be able to achieve a good ratio of cards that do and don’t show balances by keeping up to four of them at 1 to 5 percent utilization while paying the rest down to $0 each month.
See related:To boost credit score, let utilization guide you