Credit scores are an unavoidable part of life. Every time you move, apply for a job, even rent a car, your FICO credit score is checked. With a bad credit score, you’ll need to pay expensive deposits to do just about anything.
A good credit score lowers interest rates, qualifies you for better jobs, and waives deposits on many transactions.
To build good credit, you’ll need to understand the difference between loans and credit cards, how they affect your score, and how to utilize them.
First, let’s take a look at how a credit score is calculated.
Anatomy of Credit Score Calculations
Credit scores seem complicated, but they’re actually quite simple. The below table shows what factors go into calculating your credit score.
FICO Credit Score Factors and Their Percentages
|FICO credit score factors||Percentage weight on credit score:||What it means:|
|Payment history||35%||Your track record when it comes to making (at least) the minimum payment by the due date.|
|Amounts owed||30%||How much of your borrowing potential is actually being used. Determined by dividing total debt by total credit limits.|
|Length of credit history||15%||The average age of your active credit lines. Longer histories tend to show responsibility with credit.|
|Credit mix||10%||The different types of active credit lines that you handle (e.g., mortgage, credit cards, students loans, etc.)|
|New credit||10%||The new lines of credit that you've requested. New credit applications tend to hurt you score temporarily. Learn more about FICO credit score|
As you can see, payment history and amounts owed are the two biggest factors in determining your overall credit score.
The other three factors - length of history, new credit, and types of credit used - combined only affect 35% of your FICO score.
What this means is if you open too many new accounts at once, pay late, have a high debt-to-credit ratio, or don’t have a credit history, your credit score is likely to be low.
There’s no defined line for “good” vs “bad” credit, but generally over 700 indicates a good score, according to Experian, one of three major credit bureaus.
Both credit cards and loans affect your credit score in different ways. Credit cards are revolving credit, whereas loans are installment credit. The difference between these two types of credit determine how they affect your credit score.
How Credit Cards Affect Credit Scores
The 30% of your credit score that’s determined by amounts owed is where credit cards provide the biggest boost.
With revolving credit accounts, your debt-to-credit ratio can be used to boost your credit. You should be utilizing no more than 20% of your available credit during any given month.
What this means is if you have a $1000 credit limit, you should never spend more than $200 if you’re looking to raise your credit score.
If you already have several credit cards, opening a new card you don’t use bolsters your available credit without taking on new debt.
For example, if you spend $500 of your $1000 credit limit and open another card with a $1000 limit, your credit availability will be 75% instead of 50%. That’s a big increase that could make the difference between your score declining or maintaining its current level.
Be aware not to open too many credit cards are one time. Although the average American has nine open cards, opening all 9 at one time will negatively impact your score as research has shown data modelers you’re a high-risk borrower.
With a very low credit score, you’ll likely only qualify for secured credit cards.
Be sure to use these instead of prepaid debit card, as only credit cards are reported to the three major credit agencies.
With secured credit cards, you’re required to pay a deposit, which becomes your line of credit. After 6-12 months of regular payments, your deposit is either returned or applied to the balance, and often your credit limit is raised.
Regardless of whether secured or unsecured, credit cards impact your credit score both positively and negatively in the same manner.
The trick to using credit cards to improve your FICO score is to open new credit cards and use those, but do not cancel the old ones.
Letting cards sit over time will raise credit limits, which increases available credit and lowers debt-to-credit ratios. Be careful when using credit cards to repair credit to avoid common debt traps of credit cards:
- Buying more than you can afford to pay
- Paying only the minimum due
- Counting credit limits in your budget
- Rotating debt for any purpose other than lowering interest rates
- Late payments
- Missing payments
These pitfalls will keep you trapped in debt, which is what ruined your credit score in the first place. Be sure to make on-time payments and practice credit card discipline.
How Loans Affect Credit Scores
While credit cards are best suited for temporary financial relief in extreme emergencies (like your car breaking down in the middle of the desert, not that Best Buy finally has VR headsets in stock), loans are designed for long-term financial commitments.
Collateral loans, such as an auto loan or mortgage, often have 5- to 30-year repayment plans.
You’re not taking a mortgage out to purchase a home with the expectation that you’ll pay it off by the end of the month. It may take longer than that to even be approved.
As such, loans are weighted differently on your credit report. The original loan balance is counted against the current balance, but the difference isn’t available credit.
In collateral loans, this is equity. In order to borrow against that equity, you’ll need to apply for a second loan, such as a second mortgage or home equity line of credit.
Just like with credit cards, any hard inquiry outside of two per year to your credit report will lower the score by a few points.
Because of this, you have to be careful how often you ask for loans. As they quickly stack up on a credit report, this instant cash injection could quickly get you deeper in debt.
Whereas a credit card company will eventually sell your debt to a debt collection agency, a collateral lender will repossess the property.
Foreclosures and repossessions give your credit report a seven-year-long dark mark.
However, when handled responsibly, the long-term effect of paying off a large collateral, or even a business or personal loan, results in a huge increase in your credit score.
In addition, interest rates on loans are typically much lower than those on credit cards, especially as your credit improves.
Just like with credit cards, discipline is necessary to make on-time payments.
Typically the quicker you pay off the loan, the less interest you’ll pay, but some lenders (especially those specializing in customers with no or bad credit) penalize you for doing so and charge you the full term’s interest.
Here are some ways to stay safe when obtaining a loan:
- Only take what you need
- Determine how much you can afford to pay in the worst circumstance, not the best
- Ask about early payoff penalties
- Negotiate the interest rate
- Avoid balloon loans
When used properly, loans can amplify the credit repair already being performed by your credit cards.
Of course, the exceptions to this rule are payday and pawn loans. These loans should be avoided at all costs, as compounded interest rates easily ends up over 500%.
The payday loan industry is known for keeping people in debt. They also do not report payments to credit agencies, which makes them worthless to your credit and deadly to your overall financial health.
Before considering a payday loan, ask your friends and family to borrow money, as you’d rather owe anyone but a loan shark.
Credit reports aren’t as complicated as they seem. It’s nothing more than a collection of your debts and payment history.
Avoiding your credit report won’t raise your score. In fact, you need to take proactive steps to keep it moving in the right direction.
Obtaining credit cards and loans can help your credit score, but only if you make on-time payments.
Be careful about which cards and loans you choose, as not all are equal. Research your options thoroughly and ask the right questions before trapping yourself in bad debt.
By responsibly handling credit cards and loans (and knowing the differences between them), you can easily raise your credit score by as much as 100 points within a year.