Some folks have trouble paying their credit cards on time. Paying them early seems completely out of the question. Yet we got this great money tip from a reader named Steve who does just that:
I have a money tip for credit cards. Let me know what you think.
About six months ago, I started paying the amount due as soon as I received the bill. This way, I only have one month’s worth of expenses on my card at any time, rather than the two months’ [worth] I used to have when I paid it on the due date. This keeps my utilization rate low, which we know affects credit scores.
Do you think this makes enough difference to affect one’s credit score? All I know is that mine is at an all-time high and broke 800 for the first time.
Let’s examine Steve’s tip.
First, the utilization rate is the outstanding balance on revolving debt – credit cards and lines of credit – divided by your total credit limit. For instance, if you have just one credit card with a total limit of $10,000 and you’re carrying a $5,000 balance, your credit utilization rate is 50% ($5,000 divided by $10,000).
FICO calculates credit utilization in two ways. It determines your utilization for each individual credit card or line of credit. It also calculates an overall credit utilization. Both are important factors in your FICO score.
If you listen to the podcast where I interviewed FICO’s credit expert Tom Quinn, he says that the most important thing for your credit is paying your bills on time. But the second most important thing is credit utilization.
He recommends that consumers keep credit utilization below 30%. So if you have $10,000 of available credit, you don’t want your balances to go over $3,000. And the lower your utilization rate, the better. Below 30% is fine, but 20% is even better, and 10% is even better than that.
Here’s why: If you’re maxed out on your credit cards, that tells the folks from FICO that you could have a problem. If something goes wrong with your finances, you don’t have a lot of available credit to deal with it, and you’re basically living life on the edge, financially speaking.
So FICO likes to see lots of available credit. This is why keeping your credit utilization below 30% can really help keep your score up. And this is particularly important if you’re looking at buying a home or refinancing your existing mortgage in the near future.
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But why pay early?
But let’s get back to the original tip. Why does paying off your credit card bill the day you receive it versus the day it’s due help?
For credit utilization purposes, the credit bureaus take a snapshot of your credit each month. Whenever they take that snapshot, you may have a balance on your credit card. Even if you pay it in full each time the bill is due, you may still have a balance on the day they take that credit “snapshot.”
Wherever your credit utilization is at that time, that’s what the credit bureau will record into your file for that month – even if you pay off your card in full the very next day. The credit bureaus simply don’t have the resources to update your file daily.
So whatever your balance is on the day that the snapshot is taken, that’s what will be used to calculate your score for that month.
If you consistently pay off your bill as soon as you receive it, your balance will remain lower. If, on the other hand, you continue to charge up the card between receiving your bill and paying it off on the due date a couple of weeks later, your reported balance will be higher. This increases the chances that when the credit bureau takes the snapshot, your credit utilization will be higher.
Budgeting with your credit card
There is a side benefit to Steve’s tip. Paying off your credit card early can help you budget.
One of the hardest things about using a credit card is budgeting. When you swipe that credit card, the money doesn’t come out of your bank account immediately. If you’re looking at your bank account balance to decide how much you have left to spend, you may be deceived if you don’t factor in that credit card spending.
This is one of the things I like about YNAB, the budgeting software I use. I don’t look at my bank balance to decide how much money I have left over that month. I look at my budget.
But it’s tempting for most of us to look at the bank account balance. When you see how much is available, you can be tempted to spend that money, even though you’ve been spending on your credit card, too.
One thing I do to combat this problem is to make multiple credit card payments throughout the month. I just log in to my bank or credit card site to make a payment. This forces my checking account balance down appropriately, so I don’t think I have more money than I actually do.
A big thank you to Steve for sharing this tip. If you have money tips you’d like to share, shoot me an email at dr [at] doughroller [dot] net. I’d love to hear from you.