Credit cards are possibly the best tools you can use to build or rebuild your credit. But they can also be detrimental to your score if you don’t use them responsibly.
If you haven’t used credit cards before, it’s important to know that they have a high impact on your score, either positively or negatively. And there is one main reason for this—they demonstrate to creditors your ability to manage and pay off debt.
In other words, if you use credit cards responsibly, most lenders feel that you will manage other types of debt the same way. So, by all means, use them to boost your credit score, but don’t apply for one until you’re ready.
Why Having a Credit Card is Good For Your Credit
In order to have a credit score at all, you’re required to have an account open for at least 6 months. And a credit card is one of the easiest lines of credit to get. So, if you’re in the “no credit” category, this is the best and easiest way to start.
That’s not to say, though, that building a credit score from zero is the only way credit cards help. Using them responsibly can also help you rebuild a bad credit score. And they do so better than any other form of credit.
According to Experian director of public education Rod Griffin, “The consumer determines how much they’re going to charge and how much they’re going to pay each month, so there’s that element of free will that you don’t have with other types of debt.”
This is the element that makes credit cards sometimes have a higher impact on your credit score than, say, a car loan or mortgage. In other words, they hold a little more weight. Of course, holding more weight means that late payments and higher usage of your credit lines can also affect you more negatively than with other loans.
Now, you may be asking, “How does the high impact of credit cards on my report help my score?” Here’s the answer:
Your credit score is affected by several factors. And each of these factors relies on the data collected from what’s reported to the credit bureaus. We’ll go over these a little more in-depth in a moment, but this is how it works:
Length of credit history is a small percentage of your credit score that shows how long you’ve had credit. And if you have no credit at all, a credit card is the easiest way to start and establish your history. The sooner you open one, the better.
Payment history and credit utilization, however, are the biggest pieces of your credit pie.
And using a credit card is a good way to establish or start to improve on both of those. Payment history indicates how many payments you have made on time. But credit utilization is how much of your available credit you’re using.
Many credit advisors will advise clients to apply for credit cards if they are using too much of what’s already available to them. This opens up a little more available credit and boosts their score a little.
Understanding How Credit Scores Are Calculated
You might be surprised to learn that you actually have more than one credit score. And each one is calculated a little differently. What we mean is that you have a score with each credit bureau, and then you have scores with other companies, like FICO and VantageScore.
Each score is calculated using basically the same factors, but each company may weigh these factors a bit differently. For the sake of this article, we are going to dive into how your FICO score is calculated because it’s the most common score lenders use to determine creditworthiness.
There are five factors that affect your FICO score are:
- Payment history (35%). How timely you have been with payments on your accounts.
- Credit utilization (30%). How much of your available credit you’re using.
- Credit history (15%). How long you’ve had active credit accounts.
- Credit mix (10%). How many various types of credit you have (i.e. mortgages, auto loans, credit cards, etc.)
- New credit (10%). How many times you’ve opened new accounts or applied for new credit.
While it’s true that FICO always calculates your score with this algorithm, yours might look different between credit bureaus. This is because not all creditors report to all three. For example, you might have a car lender that only reports to Equifax and TransUnion.
So, your Experian FICO score may be totally different. This can either help or hurt you, depending on your payment history with the loan. Of course, it usually doesn’t make a whole lot of difference as most lenders will pull up all three scores before approving your line of credit.
Opening New Credit Card Accounts
It’s true that opening new credit card accounts is one of the best ways to build or rebuild your credit. But like we always stress, you need to make sure you’re ready to handle them responsibly before doing so.
Opening new credit card accounts increases your available credit, thereby decreasing your credit utilization. These things can help boost your score pretty quickly, especially if you had previously maxed out all your credit lines.
But when you apply for these credit cards, it results in hard inquiries on your report. Most of the time, these only take a point or two off your score. But if you apply for a lot at one time, it could start to make a difference. And when you’re trying to build or rebuild your credit, every point counts.
Running Up High Balances
If you do open a new credit card account or two, it’s also important not to run up high balances. This can hurt your credit score a great deal. This is especially true if your score was already tanked because of maximum credit utilization.
But even if it wasn’t, the purpose of opening new lines of credit should be to bring that factor down as much as possible.
Making On-Time Payments
Payment history is the most important factor in your credit score. According to FICO anyway. Because it’s weighed more heavily than the others, it’s important that you establish a solid payment history as soon as you can. This is true even if you feel like you’ve already blown it.
For one thing, those past late payments will eventually fall off your credit report, leaving you with the on-time payments you’re making now. And for another thing, it’s much easier for a creditor to overlook a negative past experience when they see your habits have changed.
Applying For a Credit Limit Increase
If you use your credit cards responsibly, you can usually apply for credit limit increases periodically. This is a good idea if your credit utilization ratio is high and you need to add availability to your portfolio.
Most credit card companies have guidelines about how often you can apply for this increase. Some require you to be a member for 6 months, while others might require a year. And most companies require you to have an almost perfect payment record during that time to qualify.
How Many Credit Cards Can You Have?
If you’re using this method as a way to help your credit utilization score, you may be concerned about the number of credit cards you have. And while there’s no simple answer for this, most experts agree that one major credit card is enough in the beginning. And there are at least a couple of reasons for this.
For one thing, having too many credit cards can be too big a temptation for some to handle. If you’ve already had financial problems in the past, it’s important you learn to manage one single card before adding to your debt responsibility.
If you end up having trouble juggling them, you could end up hurting your payment history, which holds even more weight than utilization.
The other thing to consider is your credit mix. While it doesn’t make up a huge amount of your score, it’s important to make sure you vary your types of credit. Like we said, every point counts.
In short, we suggest using one card very responsibly for a year before considering opening another.
Keeping Your Accounts Open For a Long Time
Many people think they are doing a good thing for their credit by cutting up credit cards and closing accounts. And there is something to be said for this if you consistently have trouble managing your finances. But as far as your credit score is concerned, the longer you keep your accounts open the better.
Length of credit history doesn’t account for a big chunk of your score either. But there’s more to the factor than that.
Let’s take someone who has had a pretty good payment history on a credit card for 5 years, but decides to close the account to avoid the temptation of using it.
That may sound like a great idea, and he will probably even maintain his score for a while. But in 7 years, the last on-time payment he made on that account will fall off his report. If he has other lines of credit he’s paid on time, this may not make a whole lot of difference.
But, what if he never applied for or used any other credit? In this case, he goes back to square one, with zero credit history—much like a teenager fresh out of high school.
And as you may have experienced yourself, building a credit history from scratch is almost as hard as rebuilding a really bad one.
Credit Card Best Practices
We never advise anyone to jump into opening credit card accounts irresponsibly. So, when you do, take a few pieces of advice with you:
- Only spend what you can afford to pay off.
- Avoid getting cash advances.
- Pay off balances in full every month.
- Always look for low-interest, low-fee cards first.
- Learn to manage one credit card before applying for another.
- Always make your payments on time.
Hopefully, we’ve given you a crystal clear view of how credit cards affect your credit—the good, the bad, and the ugly, as they say. In a nutshell, credit cards can build your credit score much quicker than other forms of credit. But they can also tank it just as fast.
Use them to your advantage, but do so responsibly, and you could be on your way to a better score much quicker than you imagined.