Credit cards: Myths vs. Reality
Credit cards are an important way for Americans to spend money. With the holiday season in full swing, we’ve received lots of questions from clients looking to optimize their credit card usage for points, cash back, and other perks. If you’re also wondering about these things, this post is for you.
First, some initial thoughts on credit cards:
Credit cards play an important part in determining the health of your credit score. Your FICO score, otherwise known as your credit score, can range from 300-850.
A FICO score uses five factors:
35% is your payment history
30% is your total debt
15% is the length of credit history
10% is the new credit you’ve applied for
10% are the types of credit you use
Your credit score affects just about every aspect of your life. Your credit is checked when:
you turn on utilities at a new home
you lease or buy your car; it also affects your interest rate on your new auto lease/loan
you get car insurance
employers hire you
you want to start your own business and you’re going to apply for a business loan from a bank
banks determine whether they are willing to lend you a mortgage
Credit cards are one of the largest sources of consumer debt, so healthy credit card habits have a direct correlation to a healthy credit score. If you’re not sure what a ‘healthy credit card’ habit is, you’re not alone. In our years of working with individuals, we’ve come across many rules of thumb around credit card spending that are simply not right. Here are some of the top credit card myths we’ve heard, followed by what you actually should do to keep your credit score in good standing.
Myth #1: Leaving a small balance on your credit card each month will help boost your credit score.
Reality: Since 35% of your score is based on your payment history, it’s a better idea to pay off everything in full and on time.
There is a difference between the ‘statement balance’ on a credit card and a ‘current balance’. Your statement balance is the amount you owe on your credit card as of the latest billing cycle. Your current balance is all the unpaid charges on your account - if you are using your credit card day to day, this amount may be higher.
If you don’t want to pay any interest, pay off your statement balance each month on time and in full. Our suggestion: understand your monthly cash flow and come up with a maximum amount for credit card spending each month. Automate this payment as soon as possible.
Myth #2: You can spend up to your credit limit without your credit score getting penalized.
Reality: Spending up to your credit limit is not a great idea, even if you pay it off every month. Credit utilization - or how much credit you are using compared to what you have available - should be below 30%. If it stays below 30%, your score will be unaffected. Example: if you have $25,000 credit limit, you should aim to use only $7,500 at any point during the month to keep your credit utilization below 30%.
There may be cases where you need to spend more than 30% of your limit, and that is okay, but you definitely shouldn’t make it a regular habit if you want to improve your credit score
If you are continually finding yourself spending more than 30% of your limit, you can try asking for a limit increase, which can often be easy to get if you are making regular payments in full. Every two years, it’s a good idea to call your credit card company and ask for an increase in your available credit. This is advantageous for future endeavors as well, since creditors care about the amount of credit you have available to you - especially if you don’t use it.
Myth #3: You should close your credit cards that you’re not using any more.
Reality: Longevity matters in the credit history portion of your score. Keeping your credit cards open - especially the one(s) that have been open for the longest time - is a great way to keep your credit score high. As long as there are no annual fees on your credit card, there is no real downside to keeping them.
Credit cards that are unused do close after a certain amount of time, so if you want to be sure that your card will stay open, it’s a good idea to charge one or two recurring payments on the card (ie. Netflix, Hulu) and set up automatic payments so you don’t need to think about it.
Caveat: if you have a card you don’t use that charges an annual fee, you should close this account. Just don’t close it immediately before an important event involving a credit check.
If you’re committed to using credit cards intelligently, then it makes a lot of sense to optimize your credit card usage to amplify your lifestyle. At Mana, we love the points we’re able to accrue, enabling us to travel and enjoy other recreational perks in a cost efficient way.
Deciding on the best credit card is a personal choice based on your spending and travel habits. Cards offering cash-back give you a % of your spending back in cash. Some give you a higher percentage cash back towards everyday purchases like groceries and gas. Cards that offer you points to travel will tie your spending to rewards programs - like hotels and airlines. Each airline and hotel has a loyalty program that allows you to build up point balances through credit card spending and/or flights or stays. Credit cards built for travel - and the sign up bonuses they offer - are a great way to build up points and status with your preferred airline or hotel. Credit card companies continue to innovate to attract customers. To evaluate the best credit card for you, your best bet is to head over to sites like Nerdwallet, The Points Guy, or Forbes.
Critically, there is no right or perfect credit card for any one person. Nor are there hard and fast rules about how many cards to open and maintain. Remember that all points and rewards programs are still external motivators to get you to spend, and that even the best credit card offer still needs to be balanced against the option of saving or investing that money instead. It’s also important to acknowledge that credit card rewards programs may end up changing your habits, e.g., you might become more loyal to one airline or hotel chain. This is only as advantageous as it is convenient for you. There’s almost always going to be a better deal than what your credit card offers for any one trip, but the cumulative perks and rewards may sway your loyalty decisions. Like many other elements of personal finance, we recommend keeping things simple, controlled, and tied to your longer term goals. Have fun exploring your options and considering the tradeoffs, there is plenty of personal joy and benefit to be gained from the perks of responsible spending with credit.
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Stephanie Bucko and Cristina Livadary are fee-only financial planners based in Los Angeles, California. Stephanie is the Chief Investment Officer and Cristina is the Chief Executive Officer at Mana Financial Life Design (FLD). Mana FLD provides comprehensive financial planning and investment management services to help clients grow and protect their wealth throughout life’s journey. Mana FLD specializes in advising ambitious professionals who seek financial knowledge and want to implement creative budgeting, savings, proactive planning and powerful investment strategies. As fee-only fiduciaries and independent financial advisors, Stephanie and Cristina never receive commission of any kind. Stephanie and Cristina are legally bound by their certifications to provide unbiased and trustworthy financial advice.