Credit cards and credit scores go hand in hand. But do you know how one affects the other? If not, you should - because you have the power to use this relationship to better your financial opportunities.
In order to properly manage your credit cards so that they will positively affect your score, it's important to learn the good and bad of credit cards.
Once you understand all the angles, then you'll be in a place to make sure they only help you. Let's get started.
Factors That Affect Your Credit Score
Before deciding whether or not a bank will lend you money (and at what interest rate) they will review your credit. To that end, there are five main factors that make up your credit score. They include:
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|
A FICO credit score ranges from 300-850 going from poor to excellent on the number scale.
So the higher your credit score, the better chance you’ll have to be approved for a loan or new credit card. Not only that, but a higher score will also help you get approved for lower rates.
That means a good credit score can not only give you more financial opportunity, but it can do so at a lower cost to you in the end.
How Credit Cards Affect Your Credit Score
Opening a New Credit Card
Opening a new credit card can help and hurt your score. Here's how it can hurt your score:
The length of your credit history is an important factor in your score. A new credit card account will lower the average age of your credit history, thus slightly lowering your score.
In addition, when you apply for a new credit card an inquiry is placed on your account, whether or not you’re approved.
New inquiries and credit accounts have a 10% impact on your credit score and can further decrease your rating.
But, opening a new credit card can potentially help your score more than hurt it:
Opening a new credit card can improve your score by increasing your overall credit utilization.
Since the total amount owed on all your accounts has a 30% impact on your credit score, adding in more credit into the mix will help lower the total amount you owe across the board and give your score a boost.
Closing A Credit Card Account
Some people close a credit card because they fear having it open will hurt their score. This is rarely the case. In fact, if your credit card is the first one you ever applied for, closing it will reduce the average age of your accounts and have a negative impact on your score.
In addition, you don’t want to close an account if it’s the only credit card you have. This will reduce the different types of credit accounts you have and it will lower your overall credit utilization.
In general, don't close a credit card just because you think it might hurt your score. The longer your credit history is, the better your score will be.
Using a Large Portion of Your Credit Limit
Maxing out your credit card limits will lower your credit score and could even cause you to be viewed as a high-risk consumer. It's always best to carry little to no balance on your cards. In fact, many experts suggest keeping your credit utilization at or below 30%.
For example, if you have a combined credit card limit of $10,000, then you should aim to have less than $3,000 spread across your credit cards (10,000 x 0.30 = $3,000 as the ideal credit limit utilization).
If you're currently carrying more than that on your credit cards, make a plan to start paying them off.
Missing A Credit Card Payment
Speaking of paying your balance each month, your payment history has the highest impact on your credit score than any other factor.
If you do nothing else, make paying on time your top priority. One slip up could cause your credit score to take a dive, so do what you can to avoid the risk of missing a credit card payment.
Don’t worry, though, while you should always strive to make your credit card payments on time, most lenders will only report a missed payment once the account is more than 30 days past due.
You would still have to pay a late fee and maybe even additional interest charges, but you may have some time to make up the missed payment before it’s reported to the credit reporting bureaus.
Paying Full Balance vs. Minimum Due
As I mentioned, as long as you’re making payments on time, paying the minimum amount every month still counts towards a good credit score. Financial institutions want to see a consumer who reliably and regularly makes payments.
However, paying only the minimum versus paying the balance off each month can impact your score based on two factors: your payment history and your credit utilization.
Carrying high balances can increase your total amount owed and decrease your credit score.
Likewise, you’ll have to pay additional interest on any unpaid balances, making it more difficult to pay down the principal amount.
Carrying a Balance
Carrying a balance on your credit card can have a positive and negative affect on your credit score. Creditors want to see that you’re making the most of your credit card utilization and are able to manage it properly.
Since you already know the impact that your payment history has on your credit score, focus on making regular payments on time every month and decreasing the amount you owe over time.
Using your credit card every month will help build credit - but it’s a myth that in order to build good credit you must carry a balance. Lenders want to see you using your credit - they don't need to see you carrying a balance from month to month.
Best Practices for Using Credit Cards
If you're new to the idea of credit scores, this might all sound a bit confusing at first. Luckily, you can get started with building or improving your credit by remembering a few very simple things:
- Pay your bills on time, every time.
- Keep your credit utilization below 30% (or, better yet, pay your balance in full every month).
If you do these two things, you'll be on the road to excellent credit.
Sure, there are always ways to further increase your score, such as diversifying your credit with a loan, but these basic principles are enough to get you started and will serve you well for years to come.
At the end of the day, creditors don't score consumers because they want to judge them.
They do it because they need a reliable and predictable method to understand if new borrowers are likely to pay their bills. As of right now, credit scores are the best way to do that.
So, if you pay on time every time and keep your balances as low as possible, then you'll be showing future lenders that you are responsible.
That will open the door to more credit opportunities for you in the future (think: mortgages, auto loans, rewards credit cards, and more) and it will help you get them at the lowest interest rates. All it takes is diligently following these two principles.