Credit cards are powerful financial tools with many benefits including convenience, security from fraud, and bonus rewards. But, they can also make it easy to quickly accumulate debt. In fact, about 30% of Americans have between $1,001 and $5,000 in credit card debt.
If you’re one of the millions of Americans carrying a high credit card balance, it can affect your credit score and make it challenging for you to get approved for a loan or mortgage. So, before you apply for a loan it’s always a good idea to check your credit report and see if you can make a few improvements.
Is your credit score lower than expected? You’re probably wondering:
- How does my credit utilization affect my credit score?
- Should I pay my credit off in full?
- Should I pay my credit card off sooner than later?
Read on to learn the answers to these questions, so you can take the necessary steps to increase your credit score before applying for a loan or mortgage.
How Credit Utilization Affects Your Credit Score
Credit bureaus, such as Experian®, TransUnion® and Equifax® use five main components to determine your credit score. One of the most important factors is your credit utilization rate. It’s calculated by dividing your total credit balances by your total credit limits. Experts recommend keeping the ratio under 30% to obtain a higher credit score, and under 7% to obtain the best credit score.
Let’s say you have a credit card with a $1,000 limit, and you spent $500 on purchases. Your credit utilization rate is 50% and will negatively impact your credit score. Trying to maintain a low credit utilization at all times will boost your credit score, which can help you get lower interest rates when applying for a loan or mortgage.
Why You Should Pay Off Your Credit Card in Full
It’s a common myth that carrying a credit balance helps increase your credit score. In truth, if you aren’t fully paying off your revolving balance credit cards, the unpaid portion will carry over to the next month, and you’ll have to pay interest on it. Moreover, many credit cards charge compounding interest, meaning you’ll accrue interest on top of your existing interest, and it may take years to repay your debt.
The longer you put off paying your credit card in full, the more debt you’ll have. Even if you’re making an effort to pay the minimum payment, if your remaining balance is still high, you’ll likely have a high credit utilization rate.
Why You Should Pay Off Your Credit Card Sooner
When applying for a loan, lenders and mortgage brokers can run a credit report at any point during your credit card cycle. More likely than not, it won’t coincide with the end of your billing period. So, even if you intend to fully pay off your credit card before the next payment cycle, if your credit utilization rate is above 30% at the time your credit score is reported, it will lower your score.
If you’re working with a mortgage broker to apply for a loan, make sure you pay your credit card in full before applying because it can boost your credit score, and temporarily drop your credit utilization rate. A common strategy for those focused on improving their credit score is to pay their credit card bill quickly, or when the credit utilization rate nears 30%.
The Bottom Line
Paying off your credit card immediately is the best course of action to obtain a higher credit score. Experts recommend consistently paying off credit card bills as a way to quickly increase credit scores.
Before applying for a loan or mortgage, you should also ask your loan officer to do a soft-credit inquiry rather than a hard inquiry to determine your loan eligibility and rates. Soft inquiries won’t affect your credit score and provide the same information as a hard inquiry.