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Is it bad to have a zero balance on credit cards?

Rounding it up

  • Credit scores are an indicator of one’s creditworthiness, or how reliable you are with a loan.

  • Lenders use credit scores to identify not only creditworthy borrowers but also the ones that will generate the most profit.

  • A zero balance on credit card accounts does not hurt, but it certainly does not help increase a credit score either.

  • Ask first if you really need to borrow as lenders are out to make a profit on the funds they lend you.

8 min read

Jordan T. Hedberg
#credit#credit cards#credit score#loans

Few numbers have such an impact on our financial futures as the almighty credit score. Despite the importance of credit scores for securing loans such as mortgages or car loans, how a rating agency comes up with a rating for each person remains largely a mystery to most individuals. Here, we will not only talk about how having credit cards with a zero balance impacts your credit score, but the history and evolution of credit and credit scores. Knowing the strategy of credit agencies and the lenders they serve will help the borrower make good financial decisions and avoid the many pitfalls surrounding credit.

Lenders want to know both how reliable and profitable you are. If you have a zero balance on credit accounts, you are not proving that you can borrow and pay back the money borrowed. Having a zero balance will not hurt your credit, but it will not help. To understand how this came to be, it is important to understand credit and the history of credit agencies.

5,000 years of credit

Borrowing has become such a habitual part of life in the modern world, so much so that it is easy to forget that credit is not a natural concept for humans. In fact, it’s a relatively new concept for human cultures.

As civilization started to spread across the ancient world 5,000 years ago, so did the practice of debt and credit. Civilization meant that people specialized. One person might be a farmer, the other a weaver, each focused on their narrow production. The problem became if a weaver needed wheat to eat, but the farmer did not need a shirt from the weaver, what were they supposed to do to make a fair trade?

No, they did not barter like many people falsely believe, instead, a quick solution was implemented. The farmer would give wheat to the weaver and say, “you owe me one.” It was understood that the farmer would ask the weaver for the favor when he needed it.

“I owe you,” is the basic foundation of credit. We all have said this phrase when we need to quickly borrow something. When we are in need now but do not have the funds or appropriate payment. What has changed since the farmer and weaver scenario is what is called interest. When we borrow money from banks, we’re not expected to repay just the amount owed, but also a little more to cover the time the money was borrowed. In short, the borrower must pay the lender for the time the money is borrowed with interest.

This system works well until someone that borrows fails to pay back the loan. That is where the concept of creditworthiness and score comes in.

A quick history of the credit score

What exactly is a credit score? The question is so simple that many fail to even ask why the three-digit score is important. In short, a credit score is a prediction issued by a credit agency on how likely a person is to pay back a loan.

Agencies in the United States and Canada were focused on the creditworthiness of various railroad companies that boomed during the westward expansion of both countries. The problem was that much of the wealth at that time was found in the British Empire and other parts of Europe. Scams from fake railroad companies abounded as North America spread further west, discovering more and more natural resources that could be shipped back east and across the Atlantic to Europe.

Consequently, there was an emergence of businesses who could provide investors with high-quality information on the legitimacy of these US companies. Many of these agencies are still recognizable 120 years later. For example, Henry Poor’s publishing company that focused on railroads and new canals. The Standard and Poors (S&P 500) Index in the United States Stock market still holds the name.

Some sharp business owners realized they could take the concept of the business credit rating system and apply it to individual people. One of the first major firms was Dun and Bradstreet whose agents gathered information on people who were looking to borrow from banks. Unfortunately, many of these firms often collected very personal information, and were subject to controversy over much of the 20th century.

The Atlanta Retail Credit Company gathered files on millions of Americans that included social status and often information about their sexual lives. According to a 1968 New York Times article, people lashed out against the rating agency when it digitized its records. After congressional hearings in the 1970s, the Retail Credit Company renamed itself Equifax, and the modern system of the three-credit numbers was formed.

The goal of the credit agencies in Canada and the United States remains the same: to provide lenders with a prediction on how likely a person is to repay loans via a credit score. In addition, a credit score signals to the lender how profitable a borrower is likely to be. While the collecting of private details is banned in Canada and the United States, credit agencies keep detailed records on how many credit accounts a person has, and how well they repaid those loans.

"Having a zero balance will not hurt your credit, but it will not help."

The profit motive  

To understand credit scores, borrowers need to understand the main motivation behind corporations issuing credit scores: profit.

Lenders want to know two things: will the original loan be repaid? And how much profit can they make from the borrower? Interest rates are the main way that a lender makes a profit on a loan. What the bank wants to avoid is someone that will default on a loan. This becomes a costly process of trying to collect the loan or enter negotiations with the borrower for lower payments. Sometimes, the process ends up in court. Again, this is a costly process for lenders, so they try to avoid those with a bad payment history.

With credit scores, lenders can also identify those that are great at borrowing large sums, and making those payments without fail. Many people in the modern world treat debt so naturally that they do not mind paying large fees and interest rates on borrowed money. These borrowers are a gold mine for lenders as they often charge them high interest rates plus additional fees such as monthly membership charges or administration fees during the borrowing process. Many of these interest rates and fees are regulated by Canadian law under fair lending practices, but fees and high interest rates do exist. Lenders can use credit scores to identify these profitable individuals and advertise to them directly.

Keeping a zero balance on credit cards

With the foundational knowledge of credit, credit scores, and what motivates lenders, we can finally address what happens when a borrower keeps a zero balance on credit cards.

For a credit agency to predict the borrower’s ability to repay in the future, it needs to see a history of how well the borrower repaid loans in the past.

This can create a chicken or egg problem. If you have never borrowed before, how do you promise that you can repay in the future? It is not an easy problem to solve and credit companies are reluctant to lend to people with no borrowing history.

The solution for both borrowers and lenders is credit cards. Most credit card companies will allow a borrower with no credit history to open an account. They will limit how much you can borrow, and will charge a high interest rate if you do not pay off the card every month. Regardless, it’s a first, small yet useful step for most borrowers.

Some people realize this and assume that if they open up a credit card account, but not use the account, they can build their credit score and history with no risk of having to pay interest or fees. However, credit score agencies are more clever than that. They want to see not only if you borrow, but how much of a balance you keep, how much interest you can pay, and of course, if you fail to pay any bill.

Having accounts open with a credit card company will not hurt your credit score, but having zero balances will not prove to lenders that you are creditworthy and will repay a  loan.

Lenders want to make sure you repay, and that you will also pay interest. That is why a credit score is often at its best when the borrower is paying both the principal and interest rates on a timely and regular basis. It is not bad to have zero balance on credit accounts, but it will not help you as a borrower to prove you are creditworthy to lenders.  It is also important to note that if you have too many accounts open, the lenders get worried that you will have a hard time keeping track of your bills and paying them back in a timely manner. Credit agencies like to see no more than five credit accounts open at any one time.

Ask yourself if you need to borrow in the first place

In conclusion, the best tip is to ask yourself if you really need to borrow in the first place. The best way to build financial health is to avoid taking on debt. Lenders are looking to make a profit from you as a borrower. There is nothing wrong with this, but it is important to realize that paying interest adds up quickly over the years. Money paid in interest is money that cannot be used for savings.

Borrowing is useful at certain times in life and is a perfectly usable option, but often, it can become a crutch and lead borrowers down an increasingly dangerous circle of debt, interest payments, lack of savings, and adding more debt.

If you borrow, only borrow what you really need too, and ensure that it is paid back timely. If you do this, you will be able to improve your current credit score and end up maintaining a great credit score.

Jordan T. Hedberg

Jordan is a former Broker and current community newspaper Publisher. When he is not researching and exploring the financial world he can be found raising grass-fed beef and goats in the Colorado Wilderness.

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