Is it better to pay off your credit card or keep a balance?

Carlina Teteris/Getty Images

In a perfect world, no one would ever carry a balance on a credit card. Carrying balances usually means you are paying interest on your purchases, so whatever you bought ends up costing you more than the original purchase price.

Even with low or no-interest promotions, carrying debt is a risk. Depending on how high your balances are in relation to your credit limit, you may also run the risk of damaging your credit score.

Does keeping a balance help your credit score?

Carrying a balance does not help your credit score, so it’s always best to pay your balance in full each month.

The impact of not paying in full each month depends on how large of a balance you’re carrying compared to your credit limit. Your credit utilization ratio, or the amount of available credit you’re using at any given time, is an important factor in your credit score. Second only to your payment history, it counts for about 30 percent of your total FICO score. VantageScore also uses a weighted scale, with credit utilization accounting for 20 percent of your VantageScore 4.0 score.

How credit utilization works

Here’s a simple illustration of how credit utilization works: Let’s say you have a credit card with a $500 limit and you use $250 to make a purchase. Your credit utilization ratio is 50 percent, which will likely have a negative effect on your credit score. Conventional wisdom says not to use more than 30 percent of your available credit, or $150 in this case, to keep from losing points in your credit score.

If you have additional credit cards, your credit score takes those balances into account, as well. Here’s how that might look:

• Card #1: $500 credit limit, $250 balance
• Card #2: $2,000 credit limit, $400 balance

In this case, your total credit limit is $2,500, and you’re currently using $650 of that limit. Therefore, your credit utilization is 26 percent — which is below the recommended maximum of 30 percent needed to maintain a solid credit score.

To quickly calculate your current ratio, try using Bankrate’s credit utilization ratio calculator.

How credit utilization affects your credit score

The lower you can keep your credit utilization, the better it will be for your score — assuming, of course, that all of the other factors that make up your credit score are in good shape.

Those who enjoy the best credit scores often have utilization factors in the single digits. Remember, however, that they are also doing all of the other things right — which includes paying their bills on time, not closing old accounts to maintain their credit history, having a good credit mix and only opening new accounts as needed.

Is it better to pay in full or carry a small balance?

Paying your balances in full every month demonstrates that you are living within your means. In other words, you are not using credit cards to extend your income but as a way to spend the income you already have. This is a sign of good overall financial health.

Although some consumers may carry a small balance to demonstrate that they are using the credit they have been given, neither the major credit bureaus nor FICO say this is necessary or helpful. In fact, as we’ve shown above, carrying a balance can cost you money in interest while actually hurting your credit score by reducing your credit utilization ratio.

If you are carrying a balance, it’s important to know when your credit card issuer reports your account information to the credit bureaus. In many cases, that will be at the end of your billing cycle. Your balance on that day will be what’s reported to the bureaus, and it will be factored into your credit utilization. So, in theory, you could keep a small balance on that date and pay it off the next day to show some account activity and still avoid interest charges. However, chasing the perfect credit score can lead to far more trouble than it is ultimately worth.

When carrying a balance hurts your credit score

First and foremost, carrying a balance will affect your credit utilization ratio, which makes up 30% of your credit score calculation. This applies even if you’re carrying a balance on a 0 percent introductory APR credit card.

There is also the more obvious consequence: carrying a balance costs you money through interest charges. Using low-interest credit cards and cards with 0 percent APR intro offers can help you strategically avoid or minimize interest charges on large purchases. These offers typically last for a specific period of time, often 12 to 15 months. While carrying a balance on a card like this may make financial sense, it’s important to keep in mind that it also comes with increased risk if you pass the introductory period with a balance.

The bottom line

Using more than 30 percent of your combined maximum credit limit not only carries financial risk, it can also hurt your credit score. Keeping your balances low helps improve your score while minimizing risks. The lower your balances, the better your score.

Carefully consider how you want to use your available credit based on your goals and your personal situation. Keep in mind, however, that the best way to maintain a high credit score and lower your financial risk is to pay your balances in full and on time, every time.