Have you ever heard or been told that when trying to rebuild or improve a credit score “it is a good idea to charge up your credit card, leave the balance on the card for a few months then pay it off?” Followed by, “repeat this cycle a few times because it will show that you are a responsible consumer and manage your credit well,” and by doing this over-complicated system the end result would net in a better FICO score? If you haven’t, you just haven’t been listening to enough people that are always quick to explain how you can improve your credit score. After almost 5 years of being a Certified Credit Scoring Expert and reviewing thousands and thousands of credit reports it is one of the most common tips that people share with me that someone else gave them prior to them talking with me about how to improve their score. Since it is such a popular piece of advice I have decided to address it for everyone.
This advice stems from a category of your FICO score that is most commonly referred to as your debt ratio. In simple terms it measures the percentage of debt that you currently have (balance) in proportion to the limits available on revolving accounts or the opening balance on installment debt, with the highest weight being placed on the revolving accounts. Revolving accounts and more importantly how you use those accounts have been found to be a highly predictive factor to the FICO score, thus the reason they are so important. The more predictive something is, the more important it should be to us as consumers if our goal is to improve or maintain a good FICO score.
With that as our basis, this is where the common advice takes a turn from being “helpful” to flat out wrong and destructive information. The measurement that is calculated is the percent of revolving credit being used at any given time compared to the limit. So here is a simple math exercise; if I have one credit card and the limit is $1,000 but I currently have a balance of $500 then I am using 50% of my available credit on that card, which means my revolving debt ratio is 50%. The first thing to understand as a rule of thumb is the lower your revolving debt ratio the better. In fact the best percentage you can have to maximize this piece of your score is between 1 and 2%.
If we understand the mechanics of how this number is calculated, we just need to then understand a few basics of how credit reporting works. Credit scores and credit reports are two different things. Credit reports are just complied by a bunch of data that exists about us. Credit scores happen when that data from the credit report is evaluated and analyzed to give some type of score or rank. The FICO score is measuring the statistical chance of a consumer being 90 days late or more in the next two years.
Credit scores are real time information based on non-real time data. The area where this presents the largest issue happens to be in credit card balances. The reason this can be such a problem happens to be one of the reasons why the advice being discussed here is total garbage. The due date on your credit card is not the day your balance is reported to the credit bureaus. The date your balance is reported is a day most commonly referred to as the cycle ending date or statement ending date. If I had one credit card with a $500 limit and every month I charge it up to the max, then wait for the bill to come and pay it off in full my score would be suffering all because of the timing of when I pay my bill! Credit card balances do not get updated daily, this is further proof that credit reports are full of out dated information. Also credit scores are evaluating my credit report at that moment in time; they do not look back over the history of our credit card balances. It is all about what is owed compared to the limit at that moment in time in which a score is requested.
Following this very popular and bad advice not only will help you be successful at lowering your FICO score, you will be in credit card debt plus it will cost you money as you will be paying interest charges on that revolving balance!
Here is a better approach to improving your credit; have a credit card and on a monthly basis charge 10% or less of the limit, wait for the bill to come and pay it off. Sometimes the simple approach will not only result in better results, it will save you money, time and frustration!