Does Paying Interest Build Credit?

If you have a persoanl loan, student loan, credit card, or auto loan, you might be wondering whether paying interest on such debts build credit? This post provides you with everything you need to know about interest and building credit.

Does Paying Interest Build Credit?

Paying interest on a loan, credit card, or any other type of debt does not build credit. That said, making timely payments on personal loans, credit cards, auto loans, and even student loans does build credit because your payment history accounts for 35% of your credit score.

There is a common myth out there that paying interest builds credit, but this is far from the truth. Paying interest does not build credit, it’s the act of borrowing money and paying your monthly payment on time that builds credit.

In fact, the credit scoring models do not take interest into account when calculating your credit score. Instead, the biggest factor that affects your credit score is your payment history. Your payment history accounts for 35% of your credit score.

So, if you borrow money, whether via personal loan, student loan, auto loan, or credit card and you make your monthly payments on time, you will build good credit. So, although you’re paying interest on the money you’ve borrowed, paying interest has no impact on your credit. Instead, it is the act of making timely payments that build credit.

For example, if you had a 0% interest credit card and you borrowed money and repaid, you would still build credit by making the payment on time even though you’re paying no interest.

So, the next time your friend tells you that you should keep a balance on your credit card to build credit, you now know that keeping a balance to pay interest does not build credit. Rather, focus on making your payments on time and keeping your balances low will help you build credit.

Why Doesn’t Paying Interest Build Credit?

Paying interest does not build credit because the interest you pay is not reported to the credit reporting bureaus and the credit scoring models do not factor in the interest that you pay into your credit score. So, you could be paying a very high interest rate and it will have no impact on your credit score.

So, paying interest is not a smart move, you should strive to pay as little interest as possible because that’s only money you’re paying to borrow money, it has no impact on your credit whatsoever. The smart move is to look for accounts and loans that charge you as little interest as possible so that you can borrow money for less money.

Does Carrying a Balance On Your Credit Card Build Credit?

There is another common myth out there that if carrying a balance on your credit card is good for your credit score because you pay interest. We are here to set the record straight and tell you that carrying a balance on your credit card is not good for your credit score.

Typically, the credit scoring models prefer it when you utilize as little of your available credit as possible. This is so because your credit utilization accounts for 10% of your credit score. So, the less credit you use, the better your credit score will be.

So, if you’re leaving a balance on your credit card to improve your credit, you should instead pay off your credit card for the best impact on your credit score.

As a rule of thumb, you should utilize less than 10% of your available credit and never exceed 30% credit utilization.

If you exceed 30% credit utilization, you will notice a significant drop in your credit score.

For example, if you have a credit card with a $10,000 credit limit, you should keep your balance below $1,000 for the best impact to your credit score. However, if your balance exceeds $3,000 or 30% of your credit limit, you will notice a drop in your credit score.

So, if you have the cash, pay down your credit card balances to improve your credit score because the credit scoring models like it when you pay down balances and keep them as low as possible.

As a rule of thumb, it’s best to charge only as much as you can afford to pay off every month because this will help you keep your credit utilization as low as possible, providing a decent boost to your credit score.

What Factors Impact Your Credit Score?

Let’s discuss the most important factors that affect your credit score:

1. Payment History

As previously mentioned, your payment history accounts for 35% of your credit score. So, making your payments on time is literally the best thing you can do to improve your credit score and build excellent credit. That said, missing even a single payment on a credit card or loan can cause significant damage to your credit. So, make sure to make your car loan, credit card, and student loan payments for the best boost to your credit score.

2. Credit Utilization

The second most important factor affecting your credit score is your credit utilization rate. This factor accounts for 30% of your credit score, and so you should keep your credit utilization as low as possible for the best impact to your credit score. You can calculate your credit utilization by dividing the total balances of your credit cards by the total credit limits of your credit cards. Typically, you should use no more than 10% of your credit limit and never exceed 30% credit utilization. If you use more than 30% of your available credit, you will notice a significant drop in your credit score. So, keep your balances low now that you know that paying interest does not build credit.

3. Length of Credit History

The third factor impacting your credit score is the average age of all of your accounts. This factor accounts for 15% of your credit score, and the older the ages of your accounts, the better your credit score will be. This is so because the credit scoring models reward those who have older accounts open. So, if you happen to have a credit card that you rarely use, but it’s an old account, you should try to keep it open for the best impact to your credit score.

4. Credit Mix

The fourth factor impacting your credit score is your credit mix. Your credit mix makes up 15% of your credit score and it refers to the diversity of the type of accounts you have on your credit report. For example, if you have diverse accounts, such as auto loans, student loans, credit cards, and a mortgage, this is the diversity that this factor likes and rewards you for having.

5. New Credit

The fifth and final factor affecting your credit score is the number of new accounts you’ve opened and hard inquiries that you have on your credit report. This factor makes up 10% of your credit score. The less new accounts you’ve opened and the less hard inquiries you have on your credit report, the better your credit score will be. Whenever you apply for a credit card or loan, a hard inquiry is added to your credit report, lowering your credit score. So, refrain from applying for too many accounts within a short period of time to improve your credit score.

The Bottom Line

The bottom line is that paying interest on things such as credit cards, personal loans, car loans, and other types of debt does not build credit. Paying your credit cards and loans on time is what builds your credit. You should strive to pay as little interest as possible because that will save you money. If you have any general questions or comments, please feel free to leave them in the comments section below.

Frequently Asked Questions (FAQs)

1. Does paying interest hurt your credit score?

No, paying interest is a very common part of borrowing money and repaying it, so it does not hurt your credit score. Also, the credit scoring models do not take into account the interest you pay to borrow money, so it does not hurt, nor does it help your credit score.

2. What payments help build credit?

Payments on items, such as credit cards, personal loan, car loans, mortgages, and student loans build credit.

3. Is it better to pay off your credit card or keep a balance?

It’s almost always better to pay off your credit card than keep a balance for your credit score. This is so because lowering your credit utilization (how much of your available credit you’re using) results in a higher credit score. So, to raise your credit score, reduce the balances on your accounts. Paying them off is one of the best things you can do for your credit.

4. Should I pay interest to improve my credit score?

No, you should not because paying interest does not improve your credit. Making timely payments on your credit cards and loan is what improves your credit score. So, make your payments on time.

5. Does paying interest on student loans build credit?

No, paying interest on student loans alone does not build credit. However, making your student loan payments does build credit because student loan payments are reported to the credit reporting bureaus and are factored into your credit score.