Over one-hundred and sixty million people in the US have credit cards today. Credit is a necessity for everything from renting or buying a home to making hotel reservations.
A credit card is one of the major ways people establish and build their credit. The average credit card holder owes over $15,000 in debt. How does this affect credit scores?
Credit Card Scores
Credit scores are determined by FICO, a data analytics company. The scores generated by this company measure credit worthiness of consumers. Without good credit it is difficult for people to obtain a loan and if they do, the interest is much higher.
Credit scores range from 300 to 850 and are basically like a grade. Lenders purchase and use the scores to help them decide whether to extend credit to people and to determine the interest rate that will be charged.
Credit scores are calculated using the following:
- Payment History – The history of payments on a loan, credit card or other debt is responsible for 35% of the credit score. Paying the total amount of the debt and paying on time helps raise credit scores.
- Debt Level – The amount of debt people have is responsible for 30% of their credit score. If the debt goes above 30% of their available credit, this can cause the credit score to drop. Keeping balances paid on time each month or keeping them low is best because it shows responsible credit habits.
- Length of Credit History – When a credit score is calculated the age of the accounts is used. This is responsible for 15% of the credit score. The oldest and newest accounts as well as the average of all of them are used by the FICO formula to generate a score.
- New Credit – If several credit accounts are opened in a short time, this can lower a credit score. This is particularly true for those who have a short credit history. New credit is responsible for 10% of the score.
- Mixed Credit – All accounts such as retail, finance companies, credit cards, and other credit make up 10% of the credit score. This includes inquiries.
Credit Card Balances
The amount of debt compared to the available credit is also called the credit utilization ratio. Credit agencies look at a lower credit utilization as demonstrating responsible credit use which is rewarded with higher credit scores.
For example, if $300 is owed on a credit card with a $1000 limit, a person’s credit score would be higher than someone who owes $500 on the same card.
It may be tempting to use available credit but using too much can cause a lower credit score since 30% of the score is based on the amount of debt being carried. It can also affect the VantageScore, which is another credit rating which was developed and used by the three major credit companies.
Lenders generally report to credit bureaus monthly. Making a large purchase and maxing out a card can result in lowering a credit score by 45 points or more. If the borrower is near a cut off score for a loan approval, they may be denied the loan or have to pay a higher interest rate.
A purchase that raises the credit utilization to more than 30% of the available credit may not change the credit score if this debt is paid down or off before the next statements closing date.
paying off debt
Paying off debt is the best way to raise a credit score. However, transferring the debt to a new lower interest card can result in a higher score because of increasing the amount of available credit.
Although it may cause a temporary lower score by adding an inquiry when applying for the new card, the balance-to-limit is decreased and this can raise the credit score.
The most important thing to remember when a high credit is score is the goal is to spend responsibly. Pay off debt quickly. The payment history is the next largest factor when the credit score is calculated.