As promised, here are the TMM Top 20 Dumb Credit Card Rumors, #6 - #10.
(If you missed #1-5, you can find them here)
6. “I should pay off the credit card that has the lowest balance first (or vice versa, the highest balance first).”
The initial reaction (of most people) is that you should pay off the highest balance first. Some err on the side of instant gratification and pay off the lowest balance first. But what people don’t realize is that the best strategy is neither of the above. Instead, line up your credit card statements and pay off the credit card with the highest interest rate first. Reason: The amount of interest you pay on your debt is king. If you pay off the credit card with the highest interest rate first, then you are effectively saving yourself from paying more interest than necessary.
7. “It’s ok to charge your credit card up to its maximum balance.”
This is a terrible idea. Sure, you’ve maxed out your credit card and you have a bunch of cool stuff (or not), but you’ve also showed the credit card company that you are not credit worthy. They monitor what is called a debt-to-equity ratio. It is usually best if you keep this below 30%; meaning you should avoid spending more than 30% of your available credit line. If you are over 30%, pay it down. Fast.
8. “It’s ok to pay off my credit card with another credit card.”
This is commonly called the “credit card volley.” There are a lot of ways to do this, but the basic idea is to use one line of credit to pay off another. I did this once and it was a bad move. I thought that I was smart because I used one of those “0% interest until March 200X” offers. But trust me, they get you in other ways by charging you 3% up-front for balance transfers and slapping you with high interest rates if you miss a payment. Not only that, but it reflects poorly on your credit rating if your balance shoots up on a new card and another is completely paid off. So save the genius ideas for another day.
9. “I pay bills, so I have a credit rating (ex: cell phone bill).”
Companies like your electric, utility or cell phone service provider do not report your credit standing with them to a credit bureau until you stop paying your bills – which at that point, is bad. And even then, they will sell off their “bad debt” to a collector, which will only use the “we’ll ruin your credit” threat if you don’t pay them what they ask. So do not fool yourself.
10. “It’s ok to open a store credit card for a purchase (most likely to get a discount) and then close it after it’s paid off.”
No! Resist the temptation! Opening a store credit card is like opening a regular credit card. If you open one just to close it a month later, the credit bureau will ding your credit score and they leave the record on your credit report for approximately seven to ten years (depending on the bureau) before it is removed. So, all your future creditors will see that “oops” moment and all you will have to say is “Hey, I got 20% off…”
Check back tomorrow for #11-15!
~K
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[...] (If you missed #6-10, you can find them here) [...]
What exactly are they dinging you for? Closing the account, or closing it so soon after it’s opened? Do they track that? I’ve always wondered if your credit score could reflect opportunism. Like when I took out a car loan and paid it back two months later, thinking they’d have to report me “never late.”
I’m sorry, that last comment was meant to refer to #10, “If you open one just to close it a month later, the credit bureau will ding your credit score and they leave the record on your credit report for approximately seven to ten years (depending on the bureau) before it is removed.”
I don’t agree with #6. While it is correct mathematically, it is not the most effective way to motivate someone to get out of debt. Starting with the smaller balance allows you to pay off your first card sooner which in turn motivates you to pay off more. Especially if you take the payment you were making on the first one and apply it to the next balance.
Personal finance is about more than the numbers. If people were smart about the numbers, then they wouldn’t be in the credit card mess they are in now. Read the Total Money Makeover. Follow the steps and it will change your life. It changed mine.
I would just like to point out that an unused credit line is NOT the same as equity. Equity means a surplus of assets over liabilities. So debt to equity measured by used credit compared with available credit is a misnomer. If you want to have REAL equity, you have to count your bank accounts and retirement investments less your liabilities, like credit card debt and mortgages.
Regardless of what credit bureaus or credit card companies tell you, that’s your REAL equity. If you own a home, as I do, your debt to equity ratio is probably significantly above 30%. Mine is 3.03, or 303%.
Wake up and smell the debt, people!
#6…paying off the smallest balance first and adding that finished cc payment onto paying your next smallest card is called “the snowball effect” or “the snowball method”. It’s one of the top two advised methods by financial advisors to get out of debt.
Guess the best rumor is that people understand the rumors at all. Your explainations sound clear to me. Credit is a form of equity, paying down the highest interest rate or interest amount makes sense, and you have to have credit to get credit is that is understood the moment you first try to establish credit. Oh, well good luck, you’ll need it.
I question #7, or maybe I just need clarification. I routinely get my credit card well into 70 - 80% of the available credit line… but I do pay it off each and every month. That is a BAD for your credit rating?
Or should I have assumed it meant to read “Don’t **carry over** credit card debt near its maximum”?
Noumenon – Interesting comment. I’ve never thought of the possibility that credit bureaus are dinging you for being opportunistic. It’s actually kind of funny, now that I think about it. But anyway… the “ding” that you get on your report for closing a credit card is in part due to the reduction in your debt to equity (or should I say, debt to total credit limit – as I stand corrected by Chandra’s comment – thank you). For the sake of simplicity, let’s say that you have two credit cards, both with $10,000 limits, for a total $20,000 credit that is available to you. You close a credit card – effectively lowering your total credit limit by half. If your debt was $5,000 on the remaining credit card, your debt to credit ratio just went up from 25% (5,000/20,000) to 50% (5,000/10,000). Additionally, let’s say that you had no balance and closed a credit card. Indeed, it does not hurt your debt to credit ratio… however, for some reason unbeknown to me (ask the credit bureau God’s) they “ding” you.
To sum it up, I couldn’t really tell you why they ding you in its entirety because each bureau uses a crazy “top-secret” of sorts algorithm to monitor your credit and rank you. But do you see the logic behind the debt to credit ratio? I hope it was easy to follow.
Doug- Thanks for bringing up the lingo – the method that I wrote about is indeed the “snowball effect.” You just roll one payment into the next as you pay your debt off. It works very well and is easy to maintain the payments because you get used to paying a certain amount towards your debt. Good deal!
Bob C – Thank you for the complement. It’s always appreciated!
Peter – Maintaining a high balance is usually a bad thing. I’ve used the same method in the past, which is charging for my purchases on the credit card and paying it off every month. And actually, I thought that was how credit cards worked when I got my first one. I was petrified about spending more than I could pay off and being charge interest… but one thing led to another and I got into a little more than I could handle. So I’ve been there and back. The point is: you pay it off. If you didn’t, then I would be a little more concerned. When people charge up a high balance on their credit cards, they usually don’t pay them off right away – So the answer would be that carrying a very high balance is bad. The temporary spikes should not hurt you because you are not carrying the debt from month to month- and actually it shows that you are able to manage your debt. But either way, I wouldn’t encourage it. If you can, keep your ratio lower and pay cash for more things. Let me know if there are any other questions!
~K