Credit cards can be confusing, which is why some people don't really understand how to establish a good credit score. But even though you've heard it a hundred times before, carrying a credit card balance is NOT the way to do this.
In this clip, Motley Fool analyst Gaby Lapera and senior banking specialist John Maxfield explain why this is so, how to actually build a good score, and discuss one easy tool that can help you keep track of your score from month to month.
A full transcript follows the video.
This podcast was recorded on Dec. 21, 2015.
Gaby Lapera: The one thing I hear over and over again as terrible advice is, "Carry a credit card balance to improve your credit score." I've heard this a lot, and I think it's because people don't really understand how credit scores are calculated. Credit agencies really want you to pay off your balance in full every month, if at all possible.
This is because that ends up factoring into your credit utilization ratio, which is basically how much you've spent over your total credit limit on all your credit cards. If it's over 30%, credit agencies are like, "Man, I don't know if this person can pay this back," so they start lowering your credit score. So, if you're paying a balance from month to month, you're less likely to have that below-30% credit utilization ratio that they're really looking for.
The other thing that's really important, even if you can't pay off your balance in full every month right this minute, is paying on time. Everyone knows you're supposed to pay on time, but it's something that I frequently talk to some of my friends about, and they'll be like, "Oh, yeah, I forgot to pay my credit card this month, it's OK. It'll just be a few days late, it's no big deal." And I'm like, "But it is a big deal, it's affecting your credit score every time you do that!" And I guess that's a weird thing for a 26 year-old worry about, but I worry a lot for them.
John Maxfield: I would say that's a good thing to worry about. Your credit score, at your age -- and I'm a little bit older, I don't want to reveal how much older that may be -- but, yeah, we're at that point in our lives where our credit scores matter, because we're going to be buying houses.
Lapera: Absolutely. And just in case you don't know, credit scores are really important for big purchases like that, because it dictates what kind of terms you get on your loan. So the better your credit score, the less you're going to have to pay in interest, which will save you thousands of dollars over the course of your lifetime.
Maxfield: And keep in mind, when you're talking about credit score, Gaby's going through with these five elements, there's just a formula that calculates your credit score. So, after you hear the rest of these five things, all you have to do is look it up online, figure out the exact formula, and tweak your own personal behaviors around that.
Lapera: We have nothing to do with this company, but I want to put a plug out there for CreditKarma.com. They let you monitor your credit score for free. Most credit agencies will send you a credit report for free once a year, so you only have a chance to check it three times. But Credit Karma monitors it constantly, so you can log in and check whenever you want. They update it every month, which I think is a really helpful tool for people who are just starting out, or who, like me, are worried about identity theft, because, I don't know if I told you this Maxfield, my fingerprints and social security number got stolen.
Maxfield: I didn't do it.
Lapera: I think it was hackers, I can't remember what country it was. I had security clearance. And that's out there, in the world now, fantastic.