Should you close old credit cards? Is keeping a balance a good idea? Should you have more than one credit card? We debunk the 5 most common misconceptions people have about credit cards and how they impact your credit score.
Credit 101 is a series that explores how credit really works. We discuss the basics and debunk common misconceptions. Not sure what your score is? Sign up for Credit Karma to find out for free.
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Misconception: You should close credit cards that you don’t use.
Closing an old credit card can have devastating effects on your credit score since it will lower your average age of accounts. Lenders look at this as a gauge of your experience managing credit. You should avoid closing an old credit card if possible.
If your credit card has an annual fee, you should call the bank and try to do a product change to a no-fee card. Most banks are very willing to let you downgrade products.
The biggest risk with an old credit card is that there is a recurring charge that is linked with the card and you forget to pay it in a timely fashion (since you don’t check it). This can be mitigated by setting up auto-payments.
Misconception: You should keep a balance on your credit cards. It’s bad if you pay it off completely.
You should almost never keep a balance on your credit card because of the interest you’ll pay on it. The average interest on credit cards is 15.07%, compared to the 0.06% you’ll make on average from your savings account.
The only time that it makes sense to keep a balance on your credit card is if you’re taking advantage of a 0% balance transfer offer. This is often used by people consolidating their credit card debt.
Misconception: You should utilize 30% of your credit limit. It’s not a fixed rule but it’s recommended.
This is a dangerous misconception and a recipe to get buried in debt.
It’s important to use your credit cards, but using 30% of your credit limit is impractical for most people. For example, most banks will extend creditworthy borrowers up to 40-50% of their annual income. If your annual salary was $50,000, that means it’s not unreasonable for a bank to issue you a total credit limit of $20,000 over all your credit products. Trying to use 30% of it would be $6,000 a month, or $72,000 a year ($22,000 more than your salary before considering taxes).
The credit agencies consider 0-9% utilization to be excellent. You should try to stay in this range, even if it means paying off your credit cards before the statement closes.
The main problem is that many people mix up correlate with causation. For example, Credit Karma has data showing average credit scores in relation to credit utilization. Looking at this chart alone, some people would assume that 0% utilization causes a lower credit score. The reality might be that people who have made credit mistakes (like missing payments) are extra vigilant in keeping their utilization at 0% to improve their score.
Misconception: People who have multiple credit cards are viewed as financially irresponsible by the banks.
The inverse of this is true. Credit agencies actually like to see more credit cards rather than less — Credit Karma for example considers 0-5 accounts very poor, 6-10 accounts poor, 11-20 accounts good, and >21 accounts very good — because it means you have more experience managing credit.
Does that mean you should sign up for 20 credit cards tomorrow? No. The key takeaway is that having more credit cards isn’t necessarily worse, as long as you’re financially responsible.
Misconception: You should use debit cards instead of credit cards. If you don’t have the funds, you shouldn’t buy something.
If you don’t have the funds, you shouldn’t buy something unless it adds value or increase your earning potential. However, using a credit card doesn’t necessarily mean that you don’t have the funds. As long as you have the self-control and the ability to repay the loan, a credit card always makes more sense.
Credit cards provide you with points for your transactions in the 1-5% range. As long as you’re buying something you would have bought with a debit card, it makes sense to earn cashback or points on your transactions.
Similarly, credit cards provide extremely useful benefits. All cards come with fraud protection and the ability to initiate chargebacks (if you bought an item online and received a completely different item). Some cards even offer price protection (if your price drops in the next 30 days) or travel protection (if your flight gets delayed).