When it comes to credit cards you will find a variety of advice and opinions, often very strong ones. At some point in your life you have probably even had someone you respect tell you that credit cards are dangerous and should be avoided entirely. However, before you believe the “credit cards are dangerous” advice you received from your uncle, your best friend, or even your favorite financial guru you should take a moment to consider all of the facts for yourself. The truth is that properly managed credit card accounts can actually be very powerful credit building tools.
The Danger of Credit Card Debt
First things first, while credit card accounts themselves are not inherently hazardous to your financial health, credit card debt is something that you should definitely avoid. Contrary to what you may have heard, credit scoring models do not reward you for taking on large amounts of credit card debt. In fact, quite the opposite is true. If you carry a large amount of outstanding credit card debt then you are almost certainly harming your credit scores, perhaps to a significant degree. Outstanding credit card debt lowers credit scores even if you make each and every monthly payment on time.
Why Credit Card Debt Can Lower Your Credit Scores
Consumers who carry outstanding credit card debt, especially in large amounts, represent higher credit risks to future lenders. They are statistically more likely to default on future payments than consumers who keep their credit card accounts paid off on a monthly basis. As a result, credit scoring models are designed to pay a lot of attention to your outstanding credit card debt when your credit scores are calculated.
FICO credit scores, the brand used by most lenders, actually base 30% of your scores upon the “Amounts Owed” category of your credit reports. While your credit card debt is not the only factor considered within this category, it is certainly the key factor. This means that nearly one-third of your credit scores are largely based upon the amount of credit card debt you carry.
Not only do credit scoring models pay attention to how much credit card debt you carry, but also to how that debt relates to your credit limits. The larger the distance between your credit card balances and your credit card limits the better from a scoring perspective. As your balances creep closer and closer to your overall credit limits the negative impact upon your credit scores will increase.
This relationship between your credit card balances and your credit card limits is known as your revolving utilization ratio (or sometimes your debt to limit ratio as well). Revolving utilization is calculated by determining the percentage of available credit you are currently using on each of your credit card accounts. Additionally, your overall or aggregate utilization level is calculated and considered in the calculation of your credit scores as well.
Here is a look at how your revolving utilization ratio works. If you have a credit card account with a $2,000 limit and you have a balance of $200 then your utilization ratio is 10% (not horrible from a scoring perspective, though still not best). If you charged the same credit card up to a balance of $1,000 then the account would become 50% utilized. As mentioned earlier, the higher your revolving utilization ratio climbs the lower your credit scores will fall. Paying off your credit card balances in full each month is always your best bet from both a financial standpoint and a credit score standpoint as well.
Credit Cards Are Tools
Remember, your personal actions will determine whether your credit card accounts help your credit scores or hurt them. As long as you make a habit of never charging more than you can afford to pay off in a given month and of course keep all of your payments on time then credit cards can potentially help you to build great credit. However, if you allow yourself to fall into the all-too-tempting trap of charging more than you can afford to pay off monthly then those same credit cards can not only seriously damage your credit scores but they could turn into a financial disaster in the future as well.