It’s obvious that credit cards and credit scores are tied together, but are you aware of exactly how they affect each other?
When might applying for a credit card be risky for your score? What impact do interest rates or credit limits have? How can you effectively use your credit card to your advantage and improve your score?
If you’re planning on making sense of your credit standing, it is essential to know the relationship your credit card has with your overall score. Here’s a breakdown of just how important your credit card is to the credit bureaus.
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Applying for Credit Cards and Credit Inquiries
Opening up a new line for a credit card seems like a fairly simple deal. You go to the bank (or lender), ask them if you can sign up, and then do it if you’re approved. Sometimes when you’re at a store making a large purchase for a fancy television set or an ATV, you might also consider opening up a credit card to help pay it off. Opening new lines of credit shows that you’re eager to borrow money, which should be a good sign to the bureaus, right? Unfortunately that is not always the case.
Every time you open a new line of credit, the loan office or prospective lender that is providing that line will perform a “hard inquiry” on your credit score. These evaluations of your credit standing should only be performed a couple of times a year, and having multiple “hard checks” or “hard inquiries” in a year can be detrimental to your credit score. The credit bureaus will see it as a sign that you are trying to open multiple lines of credit too quickly, which makes you look like a risky borrower.
These hard checks might not affect your score dramatically, but they will lower your score a little over time. In general, they stay on your report for up to two years. According to myFICO, they could lower your score up to five points if performed too often. MyFico goes on to say: “Inquiries can have a greater impact, however, if you have few accounts or a short credit history. Large numbers of inquiries also mean greater risk: people with six inquiries or more on their credit reports are eight times more likely to declare bankruptcy than people with no inquiries on their reports.”
Making Monthly Credit Card Payments
Arguably the most important part of owning a credit card is making on-time payments of the minimum amount due. This is not only important for keeping yourself out of debt, but this is also the most influential marker of your credit score.
As we’ve covered before when discussing your credit score, 35 percent is determined by your payment history. This means all loans, credit cards, mortgages, and even utilities and other payments can have a major impact on your credit standing. Miss a payment or two (or more), and you could see your score plummet.
Traditionally, your minimum payments will be based on a percentage of what you owe. For example, if you have a $2,000 outstanding payment on a card with 14 percent interest rate, and the minimum is 4 percent of what you owe, you will owe $80 per month. This means you will need to stay mindful of how much you can afford to pay per month. If your minimum payments exceed your limit, then you might be on the fast track to filing for bankruptcy.
Credit Utilization Ratio
Your credit score and credit card affect each other in different ways. When you’re first opening your card, your current credit score will help the bank determine your interest rate and your credit limit. Traditionally, the higher your credit score, the lower your interest rate and the higher your limit. If you have a low score that needs improving, you might still be eligible for a credit card but your interest rate and limit will reflect that.
However, once that line of credit is opened, it will begin to influence your credit score. Not only is your payment history monitored and reported, but any debt accrued on that card will also be reported to the bureaus. This is because the bureaus want to track your credit to balance ratio, or credit utilization rate. MyFICO explains: “when a high percentage of a person’s available credit is been used, this can indicate that a person is overextended, and is more likely to make late or missed payments.”
As a general rule of thumb, try your best to stay below the 30 percent mark on your utilization rate. You can find your utilization rate by dividing the amount you owe by the total credit limit you have. If you have three credit cards, and a combined limit of $25,000, but are only using $7,000, your utilization rate is 28 percent. ($7,000 / $25,000 = .28 or 28 percent)
Age of Accounts and Canceling Credit Cards
Every banker will tell you that closing your credit card account is a bad idea. But perhaps they have a biased opinion? Is it really that bad to close your credit card account after you’ve paid everything off?
According to myFICO and the credit bureaus: yes, it can be bad. The action of closing your account isn’t detrimental, but the sudden loss of available credit is damaging. Your utilization rate will drop, since your total credit limit will be lowered, and your credit history (as in the amount of time you’ve had each account open) will also lower. Both of these variables are important in determining your credit score.
As myFICO explains, even if you don’t need the card anymore (or want to remove the temptation), don’t close your account. Instead, be mindful of the cards you do open, and be sure to only sign up for offers that benefit you.
Credit cards have an obvious impact on your overall credit score, but it’s important to know the nuances of the relationship between the two. Having a better understanding will help you keep your score high and your finances in check. Knowledge is power!
Find more information about credit cards at our credit card resource center. What else affects your credit score? Find out at our credit score resource center. Is there an entry for a credit card you don’t own on your credit report? Use one of our dispute letter templates to contact the credit bureaus.
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