Credit cards are powerful tools that can help you build excellent credit — but they can also sink your finances.
Rebecca from Brooklyn says, “I really do enjoy the Money Girl podcast and listen as much as I can. As a 24-year-old, I’m new at my job and at managing money and I think it can be scary. But your podcast has helped ease my confusion and anxiety. My question is about the good, the bad, and the ugly of using credit cards. How do credit cards help you build credit and what are some healthy ways to manage cards and credit?”
Thanks for your question, Rebecca. I’ll answer it by starting with an overview of how the credit scoring system works, to make sure you understand the rules of the credit game. Then I’ll explain how to use this information to build and maintain excellent credit for life.
How Do You Build Credit?
Many people have no idea how the credit system works. They may not care until they need a credit card or want to finance a big purchase, such as a car or home, and get denied.
Unfortunately, most of us are never taught about credit in high school or college. So, it’s no wonder that many people struggle to improve their credit. If you don’t understand all the components that factor into your scores, your credit rights, and various ways to build credit, you’re at a serious disadvantage.
Here’s an overview: Information about you gets reported to one or more credit bureaus that maintain the data in your file, known as your credit report. Then companies who want to access your credit report pay the bureaus for your information.
Credit bureaus don’t make lending decisions; they maintain your data. But credit reports can be huge, so companies want a quick way to evaluate you. That’s why credit scores were designed — they’re a snapshot of your current credit situation.
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Understanding Credit Scores
Credit scores are calculated from the information in your credit reports. And there are hundreds of different credit-scoring models in use. So, you actually have many credit scores, not just one.
Some scores are proprietary systems that lenders create for themselves, and others are well-known, such as the FICO, which stands for the Fair Isaac Company, which created it. But even FICO offers dozens of different scores. There are newer versions and some just for specific types of products, such as mortgages, credit cards, and auto insurance.
FICO also markets different scores that are custom-made for each of the nationwide credit bureaus. They tweak the underlying algorithms for different scores and roll them out periodically.
The FICO score ranges from 300 to 850. More than half the U.S. population has a FICO score of 700 or higher. Many lenders use a FICO score of 740 as the cutoff for having excellent credit and giving you their best rates and terms.
TransUnion’s TransRisk score ranges from 300 to 850 and the Equifax Credit Score ranges from 280 to 850. Experian has a score that ranges from 360 to 840. And there’s a score that the credit bureaus created together, called VantageScore, which ranges from 501 to 990.
So, you see that there are similarities, but no two credit scores are the same. Each scoring model evaluates you a little differently and gives different “grades.”
No matter which type or brand of credit score that a company or individual uses to evaluate you, scores are simply a snapshot of your credit information. As new information is added to your credit reports and old information is deleted, your scores are constantly changing. The higher your score, the more trustworthy and responsible you appear.
I don’t want you to worry about seeing or keeping track of every possible credit score because that would be impossible to do, and it really doesn’t matter. Instead of getting caught up in the nuances of different scoring models, focus on the big picture.
By concentrating on what’s in your control and improving your financial behavior so more positive information gets added to your credit reports, you’ll be in good shape.
Another important concept to understand about the credit system is that every person has his or her own credit reports and credit scores. In the U.S., your credit data is compiled and tracked by your Social Security number. That means any resident who qualifies for a Social Security number can build a credit file in the U.S.
Your credit information is never merged with someone else’s, even when you’re married. Spouses each have individual credit reports and scores, which is why it’s so important to build your own credit history. If you co-sign a loan or a credit card application with someone else, both of your credit scores are evaluated in the approval process.
Because credit scores are based on your credit reports, it’s critical to know what’s in those reports.
To sum up, a credit score is simply a number that represents a current evaluation of the data in your credit report. Because credit scores are based on your credit reports, it’s critical to know what’s in those reports.
Here are several free sites where you can review your credit reports for free:
How to Use Credit Cards to Build Credit
Credit cards are powerful tools to build credit when used responsibly. If you don’t pay them on time or rack up high balances, they will crush your credit.
Credit scoring models analyze the total amount of debt you owe on all your accounts. Additionally, for your revolving accounts, your available credit is a major factor that makes up about a third of your credit scores.
Revolving accounts are the ones that stay open indefinitely, such as credit cards and lines of credit. They don’t have a set maturity or pay off date and give you a set credit line to spend. As long as you make monthly minimum payments on time, you can continue to use revolving accounts forever.
Installment loans, such as car loans and mortgages, are different because they don’t have a credit limit and do come with a set maturity or pay off date. When you pay down an installment loan to zero, the account is closed.
A key formula that’s used to calculate your credit scores is called your credit utilization ratio. It’s used only on revolving accounts. It’s a simple formula that compares your credit limits to your outstanding balances. This ratio shows how much available credit you’re using.
Keeping a low utilization, such as below 20 percent, is optimal for good credit. So, by paying down your balance on the card to $400, you could reduce your utilization ratio from 50 percent to 20 percent ($400 / $2,000 = 0.20) and boost your credit scores.
A low utilization ratio tells potential lenders and merchants that you’re using credit responsibly. A high ratio says you’re maxed out and may even be getting close to missing a payment. To maintain the best credit possible, never let your utilization ratio exceed 20 percent to 25 percent.
Using credit cards responsibly is critical because your credit utilization typically makes up about 30 percent of your credit scores. This is second only to paying your accounts on time, which may account for approximately 35 percent of your scores.
When Is Credit Utilization Calculated?
A common misunderstanding about credit utilization is that it doesn’t matter how much you charge, as long as you pay off your entire balance by the statement due date each month. While I’m a huge advocate of paying off your credit card in full every month so you stay out of debt and avoid all interest charges on a credit card, it can still hurt your credit.
Here’s why: Credit cards report your payment information and account balance to the credit agencies on a given day each month. This date is typically not the same as your statement due date. It doesn’t matter whether you pay the balance off in full by the due date — the balance you owe on the reporting day is what shows up on your credit report.
So, even if you always pay off your balance in full, you can still have an outstanding balance on your report, and a high utilization ratio! The key is to keep your balances below 20 percent to 25 percent of each card’s limit, even if you plan to pay it off right away. Otherwise, a larger-than-expected balance will appear on your credit report.
If you use credit cards responsibly but still charge more than 20 percent of your available limit, one solution is to apply for a credit limit increase using your online account or by calling the card company. For instance, if your credit card limit was raised from $2,000 to $4,000 and you still owe $1,000, that drops your utilization substantially from 50 percent down to 25 percent, which is much better for your credit scores.
Another strategy to increase your credit scores is to use multiple cards so you spread out usage, so you never go over 20 percent of your credit limits. It’s much better to have two credit cards that each have balances below 20 percent of your credit limits than to have one card with a 40 percent utilization ratio.
Getting additional credit and spreading out your card balances can improve your credit scores quickly. Also, note that credit scores factor in both your ratio on individual revolving accounts and on the total of all your revolving accounts.
To learn more about taking control of your credit and pursuing your financial dreams, check out my online class, Build Better Credit—The Ultimate Credit Score Repair Guide. It teaches all aspects of building credit from scratch, how to prepare for a major purchase, and dealing with creditors wisely.
6 Ways Credit Affects Your Finances
If your goal is to build credit so you can qualify for a mortgage or other large loan, that’s terrific. Having higher credit scores allows you to get approved for the best terms and lowest interest rates.
But besides cutting interest, your credit affects many other aspects of your everyday life, even if you don’t borrow money! There are a variety of companies and industries that use credit to evaluate you, even though they’re not giving you a loan or a credit card.
Here are six ways credit affects your finances even when you don’t borrow money.
Employers in most states have the right to check your credit reports, with your permission. Although the credit report available to employers is slightly different than the version a potential lender can see, it can still reveal any financial problems you might have.
Checking your credit is common for certain jobs and industries, such as working in finance or being in upper management, and it’s becoming a more widely used practice for all types of job screenings.
The idea is that if you have a poor credit history, you might not be disciplined or responsible when handling money. Employers may fear that you have the potential to steal or that you’ll be distracted at work due to financial troubles and not offer you a job.
Most landlords, property managers, and leasing companies check your credit as part of the application process to make sure you’re likely to pay rent on time. If you have poor credit you may get turned down to lease or have to pay a larger security deposit.
3. Cell phone contracts
Cell phone companies check your credit when you apply for a new contract to make sure you’ll pay their bill. If you have poor credit you may be charged higher rates, a higher security deposit, and not qualify for top-tier wireless plan offers.
Credit also plays a big role in utilities, such as water, gas, power, and cable service. Applying for these services is applying for credit — so having poor credit makes it difficult to get them. You might have to pay a hefty security deposit, get someone with good credit to co-sign your application, or get a letter of guarantee from someone that says they’ll pay your utility bill if you don’t.
5. Auto insurance
Auto insurance is regulated by states, so the rating rules vary depending on where you live. While no state allows credit to be the only factor in setting auto rates, a few states have banned its use completely.
6. Home insurance
Just like with auto insurance, home insurers also use your credit when setting rates for home, condo, and renters policies. Again, no state allows credit to be the sole factor in setting home insurance rates, and it’s prohibited in several.
This isn’t a complete list of all the ways credit affects your finances but may be the most eye-opening. The main point to remember is that when you build credit, not only do you become eligible for credit accounts, but you save money and improve your overall financial life in multiple ways.
This article was originally published on Quick and Dirty Tips.
Published by Debt.com, LLC