Banks and credit card companies are great at making money. However, they are not very trustworthy when it comes to financial advice. Getting financial advice from a bank is like getting nutrition advice from a burger and fry joint. Don’t get me wrong, I love a good burger and some fries, but I certainly will not get nutrition, health, or fitness advice from a burger joint. For that matter, I certainly will not get financial advice from a bank, and I recommend that you follow suit.
Banks and credit card companies make money off of loans and interest. As a result, there is a philosophical mismatch when it comes to “financial responsibility.” They want more of your money, and they will make up some sob story saying that paying interest improves your credit score.
The reality is that paying interest does not improve your credit score. When a bank or credit card company tells you that you should keep a balance on your credit card, or not pay off a loan quickly, because you will miss out on the improved credit score, know that they are telling you that because it is in their best interest that you pay as much interest as possible.
However, in the interest of full disclosure, I will explain why the banks are not COMPLETELY wrong when it comes to this myth. In this post, I will debunk the myth that says that paying interest will improve your credit score. However, I will also point out how banks are not COMPLETELY wrong.
If you showed me a blue pen and said it was red, I would say that you’re wrong. However, if you gave me a pair of red tinted glasses, then yes from that viewpoint, the pen would be red. This is the exact same paradigm that makes the myth about paying interest carry a small amount of water. However, it still fails the cause and effect test.
Payment history makes up 35% of your FICO credit score. Having a positive payment history will go a long ways towards having a good credit score. Conversely, having a poor payment history will heavily contribute to a poor credit score.
Allow me to introduce two hypothetical people. George and Susan carry the exact same amount and type of debt; however they pay their debts at a different rate. The debt that both of these people carry is a $200,000 mortgage with a term of 15 years and an APR of 5%. The minimum payment is $1,581.59 per month.
George makes the minimum payment on time every month, does not miss a payment, and ends up with 15 years of good credit history as a result of his mortgage. He paid a total of $84,686.20 in interest [($1,581 per month X 12 months X 15 years) – $200,000 principal].
Susan decides that she does not want to be in debt for 15 years, so she accelerates the pay-off. By paying $2,500 per month, Susan finishes off the mortgage in just over 8 years (97 months). She pays a total $42,500 in interest [($2,500 per month X 97 months total) – $200,000 principal]
While both had positive credit histories (paying early or on time and never missing a payment), George would end up with the better credit score, all other things held equal. The reason why is simply because he had a longer positive credit history than Susan.
I would be willing to bet that both George and Susan would have excellent credit scores, but George’s would be a little bit higher.
While George’s credit score would be higher as a result of the circumstances, it should be noted that he paid almost TWO TIMES the interest that Susan paid! So who really “won” in that situation? I would say that Susan got the last laugh.
We have to consider cause and effect. George’s longer positive payment history caused a higher credit score, not the additional interest paid. While the higher interest and the higher credit score are correlated, there is no causal relationship. After all, interest does not get factored into FICO’s credit score calculations. But banks like to ignore cause and effect and just say “hey, he paid more interest and has a higher credit score!”
You can apply this to any type of debt that you would like, however the principle remains true. Paying more interest does NOT result in a higher credit score!