Carrying a Balance Builds Credit and Six Other Borrowing Myths, Tested

Let me tell you how a myth about money gets started. Somebody in the break room says it with total confidence. Somebody else repeats it at a barbecue. A lender, a salesman or a website with a cheerful mascot finds that it helps the sale, and says nothing to correct it. Within five years the myth has the force of common law, and nobody remembers that it was never in the statute book.

Borrowing is the field where this happens most, because the numbers are slippery and the stakes are large. A wrong idea about a credit card or a car loan does not cost you a bad afternoon. It costs you years of payments. So here are seven claims I hear constantly, each stated fairly, each tested against arithmetic and the law, each with a verdict.

A caution before we begin. This is general information, not financial or legal advice for your circumstances. The figures are labeled illustrations, chosen to make the arithmetic clear. Your rate, your lender and your state will differ.

Myth 1: Carrying a balance on your card builds your credit

The claim. You have to carry a balance from month to month to show lenders you can handle debt. Paying in full is nice, but it does not help the score.

The test. The factors that make up a typical credit score are your payment history, the amount of your available credit you use, the length of your history, new applications and your mix of accounts. Nowhere on that list is "paid interest." What the scoring model sees is that you have an account, that you pay it on time and that you use a modest portion of your limit. Whether you then pay the balance in full or let it roll makes no difference to the score. All that rolling does is hand the card company interest.

Do the arithmetic. Suppose you carry a $1,000 balance at 20 percent annual interest, a hypothetical rate. Over a year, if the balance stayed the same, you would pay about $200 in interest. For that money, you receive nothing the score values. Had you paid in full, the card would still have reported a balance on the statement date, a payment made on time and a good use of your limit. The details of how the score is built are in How a Credit Score Is Built and Why Paying on Time Beats Every Trick.

Verdict: false, and expensive. Use the card, pay it in full, and keep the $200. A story that costs the customer money and makes the lender richer should make you suspicious of who told it first.

Myth 2: The minimum payment is the safe, responsible amount

The claim. The card company says you owe at least this much each month. If they set it, it must be fine.

The test. The minimum payment is the smallest amount you can pay without being marked late. It is designed to keep you in good standing, not to get you out of debt. Look at the mechanism with a labeled illustration. Suppose you owe $5,000 at 20 percent annual interest, and you pay a flat $100 a month. Twenty percent a year is about 1.67 percent a month, so the first month's interest is about $83.33. Of your $100, $83.33 goes to interest and only $16.67 reduces what you owe.

Run that forward. Paying $100 a month on those terms takes about 109 months, a little over nine years, and costs roughly $5,840 in interest on a $5,000 debt. You will have paid back more than double what you borrowed. (Actual minimums are often calculated as a percentage of the balance with a floor, so real schedules differ; the point is the shape.)

Verdict: false. The minimum is the card company's number, not yours. It keeps the account open and the interest flowing. If you cannot pay in full, pay as much above the minimum as you can, and see Debt Snowball or Debt Avalanche? Two Payoff Plans Run on the Same Four Debts for a plan to attack the balance.

Myth 3: A car payment is a normal part of life, forever

The claim. Everybody has a car payment. It is just a monthly bill, like the electricity.

The test. A car payment is a loan on an asset that loses value. Take a labeled illustration: a $30,000 vehicle financed at 7 percent for 72 months. The payment comes to about $511.47 a month. Over six years you pay about $36,826 in total, which means roughly $6,826 in interest on top of the price. Meanwhile, the car loses value every year you drive it, so for a good part of the loan you may owe more than the car is worth.

Now imagine the cycle. You trade the car in after six years and roll the remaining balance into the next one. You are never out of payments, and each cycle begins with a larger debt against a car that is already worth less than the loan. That is the "forever" part. It is not a law of nature. It is a habit, and a profitable one for people who finance cars.

The alternative is to drive a reliable car past the last payment and to treat the old payment as your own money. That is the argument in The Paid-Off Car Is a Raise, the Arithmetic of Driving Your Car Longer, and it is worth reading before the next dealership visit.

Verdict: mostly false. A car loan can be sensible when the vehicle is needed and the terms are short. A permanent car payment is a choice, and an expensive one.

Myth 4: Debt consolidation always saves you money

The claim. Roll all your debts into a single loan and you will pay less.

The test. Consolidation can save money, and it can cost you more. The difference lies in two numbers, the rate and the term, and the monthly payment can disguise both.

Here is a labeled illustration. Suppose you have $15,000 in card debt at 22 percent. If you paid it off over 60 months at that rate, the payment would be about $414.28 and the total interest about $9,857.

Option one: you consolidate into a 60-month loan at 12 percent. The payment falls to about $333.67 and the total interest to about $5,020. You have saved about $4,800 in interest. That is a real win: lower rate, same term.

Option two: the lender offers a lower payment by stretching the loan to 120 months at the same 12 percent. The payment falls to about $215.21 a month, which feels wonderful, but the total interest rises to about $10,825. That is more than you would have paid on the card over five years. You lowered the payment, and you raised the cost.

There is a third trap, and it is the worst. After you consolidate, the credit cards you just paid off sit with empty limits, and the old habits are still in the house. If the cards fill up again, you now have the consolidation loan and the new card debt.

Verdict: false as stated. Consolidation saves money only when the rate falls and the term does not stretch, and only if you stop adding new debt. Always compare the total interest, not just the monthly payment. A salesman who talks only about the monthly payment is hoping you will not do the multiplication.

Myth 5: Bankruptcy erases everything

The claim. If your debts get bad enough, file for bankruptcy and all of it goes away, student loans included.

The test. Bankruptcy is a lawful, constitutional remedy. The Constitution itself, in Article I, Section 8, Clause 4, gives Congress the power to establish "uniform Laws on the subject of Bankruptcies throughout the United States." It is a legitimate fresh start for a debtor who truly cannot pay. But it does not erase everything.

Some kinds of debt generally survive a bankruptcy. These include most child support and alimony obligations, certain tax debts, and debts for certain wrongful acts. And then there are student loans. Under the Bankruptcy Code, section 523(a)(8), educational loans are not discharged unless the borrower shows that repayment would impose an "undue hardship" on the borrower and his dependents. The Code does not define the term. Courts have developed tests for it, and a well-known one comes from a 1987 Second Circuit decision, Brunner v. New York State Higher Education Services Corp., which asks, in general terms, whether the borrower cannot maintain a minimal standard of living if forced to repay, whether that situation is likely to persist, and whether the borrower has made good-faith efforts to repay. Different courts apply different standards, and the process is difficult and uncertain.

Bankruptcy also has costs. A filing can remain on a credit report for up to ten years, it has fees and it requires a lawyer in practice for anything beyond the simplest case. It is a serious step, not a shortcut.

Verdict: false. Bankruptcy can discharge many debts, but not all, and student loans are the hard case. If you are considering it, talk to a licensed bankruptcy attorney, and be wary of anyone who promises that everything will vanish.

Myth 6: A debt settlement company can do what you cannot

The claim. For a fee, a professional will negotiate your debts down to pennies on the dollar, and you could never get that deal alone.

The test. A creditor can agree to accept less than the full amount, and it sometimes does. Nothing in the law prevents you from calling the creditor, explaining your situation and asking. That is the whole of what a settlement company does: it calls. The difference is the fee and the method.

Many such companies tell you to stop paying your creditors and send money to an account until there is enough to offer a lump sum. In the meantime, late fees and interest pile up, your credit takes damage and a creditor may sue you. The savings that are promised can be eaten by the fees and the penalties. The Federal Trade Commission's Telemarketing Sales Rule, as amended in 2010, generally forbids debt relief companies that sell by phone from collecting fees before they have actually settled or reduced a debt, and then only for the debt they settled. If a company asks for an up-front fee, that is a warning.

There is also a tax wrinkle: debt that a creditor forgives may be treated as taxable income in general, and a creditor may send a form reporting it. Ask a tax professional before you settle anything.

Verdict: mostly false. You can do what a settlement company does, for free. Non-profit credit counseling agencies can help you set up a repayment plan, and the legitimate ones are open about fees. Check any company's reputation with your state attorney general before you give it a dollar.

Myth 7: "Good debt" never hurts

The claim. Some debt is good, such as a mortgage, student loans and business loans, because it builds your future. The only bad debt is credit card debt.

The test. There is a true statement hidden in this one. Borrowing to buy something that produces more than it costs, such as a modest home, a trade certification or a business with real customers, can be a wise use of credit. That is how many American families got ahead, and it is a rational use of other people's capital.

But the label does not make the debt safe. The test is not the category of the loan; it is the arithmetic of the particular loan. A mortgage that stretches the monthly budget past what a family can carry is dangerous even if it is "good debt." A degree financed with large loans that leads to a job that cannot repay them is a burden, and it is the one debt that bankruptcy rarely clears. A business loan on a weak idea is a fast way to lose your savings and, if you signed a personal guarantee, your house. The Side Business Test, How to Know Whether Your Idea Can Pay Its Own Way is a sober look at that last one, and Seven Myths About Owning a Home That Cost First-Time Buyers Real Money covers the first.

A better rule: ask what the debt buys, what it costs in total, and what happens if your income drops. If you cannot answer all three, it is neither good nor bad. It is simply unexamined.

Verdict: half true, and dangerous when taken whole. Some debt can be a tool. All debt is a claim on your future income. The word "good" is not a safety certificate.

Why the myths survive

You might ask why so many of these are so widely believed. Part of the answer is that they are convenient for someone. The idea that you must carry a balance is convenient for a card issuer. The idea that a car payment is normal is convenient for a lender. The idea that a lower monthly payment means savings is convenient for anyone selling a long loan. None of these businesses needs to lie. They only need to let the myth stand.

The other part of the answer is that the arithmetic is boring. A myth is a story, and a story beats a spreadsheet every time. That is why the habit worth building is the habit of asking for the total. Total interest, total cost, total time. A person who always asks "what is the total?" is very hard to sell a bad loan.

There is a moral side here as well, which I will state as a value and not a fact. The tradition I stand in treats debt with seriousness. The Book of Proverbs says the borrower is servant to the lender, and the old counsel of thrift in the American tradition was that a man should owe nothing that he could not see his way to paying. Our grandparents did not think of themselves as thrifty because they enjoyed it. They did it because they understood that freedom has a balance sheet. Benjamin Franklin, in The Way to Wealth, warned against the habit of going into debt for things you do not need, an argument you can read in Benjamin Franklin's The Way to Wealth, Read Line by Line for Modern Savers.

A family with an emergency fund and a plan can borrow when it makes sense and decline when it does not. Why the Emergency Fund Comes Before Every Other Money Goal You Have is where that begins.

The case in brief

1. Carrying a balance does not build credit; paying on time and using little of your limit does, so pay in full and keep the interest.
2. The minimum payment is built to keep the account open, and on $5,000 at 20 percent with a flat $100 a month, it takes about 109 months and about $5,840 in interest.
3. A car loan and a consolidation loan should be judged by total cost: $30,000 at 7 percent over 72 months costs about $6,826 in interest, and stretching a consolidation loan to 120 months lowers the payment while raising the interest.
4. Bankruptcy, which the Constitution authorizes in Article I, Section 8, does not wipe out everything, and student loans require a showing of undue hardship; settlement companies sell what you can attempt yourself, and up-front fees are a warning.
5. "Good debt" is a tool and a claim on your future income, and the test for any loan is what it buys, what it costs in total and what happens if your income falls.

What you can do: take the loan or card with the highest rate in your household, find its payoff amount and interest rate on your latest statement, and write down the total interest you will pay at your current payment.