Credit cards are a convenient way to pay for purchases without the hassle of writing out a check or carrying around a wad of cash. However, under various scenarios, credit cards can have a negative impact on your credit score, which can lead to higher interest rates or even being denied loans such as a mortgage for your first home. Knowing the potential pitfalls of using a credit card helps you take advantage of card benefits without your credit score suffering.
Credit Score Basics
Your credit score takes into account a variety of information about your financial history to calculate how risky you are as a borrower. The five factors for your credit score are payment history, amounts owed, length of credit history, new credit applications and types of credit used. Scores range from 350 to 850, with a "good" score typically being over 700. Three main credit bureaus, Experian, TransUnion, and Equifax, keep a file on your financial history and calculate your score based on that information. You can order your credit score from the credit bureaus, usually for a fee. However, if you just want to check your credit report, you are entitled to a free credit report from each of the three main credit bureaus that will show the information used to calculate your score, but not your actual score.
Poor Payment History
According to the Fair Isaac Corporation, which develops the algorithm for calculating credit scores, 35 percent of your credit score is determined by your payment history. This makes your payment history the single most important factor in calculating your credit score. When you have a credit card, your payment history includes whether you pay your monthly bill on time or not. If you are late with payments, skip payments, or default on your credit card, your credit score will suffer.
Carrying a High Balance
The second biggest factor in calculating credit scores is the amounts owed, at 30 percent of your score. This includes balances you carry on your credit card, as well as the ratio of your credit card debt to your credit limit, also called the utilization ratio. Ideally, you should not use more than 30 percent of your credit line at any time, either on any single card, or on all of your credit cards combined. Maxing out your credit cards lowers your credit score because you are viewed as a higher default risk.
Applications Ding Credit Score
Each time you apply for a new credit card, the credit card company pulls your credit report to determine whether to issue you credit, the interest rate to charge, and the amount of your line of credit. This credit check is then added to your credit history. Each inquiry on your credit report lowers your credit score by a few points. Each inquiry affects your credit score for two years, but only inquiries from the most recent 12 months actually affect your score. Therefore, if you apply for a number of cards in a shorter period of time, your credit score can suffer.
Too Many Cards
Having too many credit cards with high balances and high credit lines may negatively affect your credit score. The number of credit cards that is "too many" depends on your credit profile, but is typically around seven credit cards. However, this only affects your mix of credit portion of your score, which accounts for just 10 percent of your score. Therefore, too many cards is likely to have a minimal impact as long as you keep your balances low any pay on time.
- myFICO: Credit Inquiries
- myFICO: Inquiries
- myFICO: What's in Your Credit Score?
- Kiplinger: Tame Your Credit Card Debt
- Federal Reserve: Consumer Information: 5 Tips: Improving Your Credit Score
- Motley Fool: Cancelling Credit Cards
- Bankrate: Improve Credit Score By Using Credit Cards
- myFICO: About Credit Scores
- Bankrate: Taking a Look at Good Credit
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