Credit cards can be a blessing or a curse, for a few reasons. If you overspend on your cards and owe interest, you could end up in a bad financial situation -- the average credit card interest rate is 21.47%, according to the Federal Reserve Bank of St. Louis. But if you pay your credit card bills on time all the time and earn rewards, they can actually help improve your personal finances.
There's another important reason why credit cards could make your financial life either much better -- or much worse. Credit card usage can have a huge impact on your credit score. And this number is critical, since landlords and most other companies you want to do business with are going to look at this score. They use it to determine if you're a reliable, good customer to work with, or unreliable and someone to be avoided (or charged more to borrow).
So, how can credit cards help -- or hurt -- your score? Here's what you need to know.
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1. They can affect your payment history
Your payment history is the most critical part of your credit score, accounting for 35% of your FICO® Score (one of the most popular and widely used credit scoring systems).
When you pay your credit card on time -- or pay it late -- this is reported to the credit bureaus and it becomes a part of your record. A single payment that's 30 days late could cause a drop of more than 100 points in your credit score if you previously had good credit. But a history of on-time payments reflects well on you as a borrower, and you'll see a better credit score as a result.
You can make sure you pay on time, and don't hurt your credit record, by setting up autopay for the minimum amount due every month. Ideally, set up a payment for the full amount due, as long as you aren't worried you could potentially overdraft your bank account. Doing this will help you avoid interest charges.
2. They can impact your utilization ratio
The second most important factor in your FICO® Score is your credit utilization ratio, which accounts for 30% of the FICO scoring formula. Basically, your credit utilization ratio is a measure of what you owe versus what you could potentially borrow. So if you have a $1,000 credit line and have borrowed $300, you'd have a 30% utilization ratio.
Higher credit utilization ratios are a red flag resulting in a lower credit score, because using too much of your available credit suggests you may not have control over your spending and could get in over your head. If you keep your ratio below 30%, on the other hand, you could earn a better credit score.
Maintaining a lower utilization ratio simply means you can't charge too much at once. If you have a $1,000 limit, try to keep your card balance well below $300 if you can. You can make this easier by requesting higher credit limits when your card issuer offers them (you can sign into your online account to see if you have the option to request a credit line increase).
3. They can help determine the average age of your accounts
If you have a long history of using credit responsibly, that's better than a short history since lenders have more data to determine if you'll be responsible. As a result, 15% of your FICO® Score is determined by average account age.
Opening a bunch of new credit cards at once, or closing old card accounts, results in a shorter credit history that hurts your score. Keeping old cards open, on the other hand, can help it. If you have a card you've had for a long time, you should avoid closing it even if you don't use it very often.
4. They can give you a different kind of credit
Under the FICO formula, 10% of your credit score is based on the different types of credit you have. So, if you've only got installment loans like an auto loan or mortgage, adding a revolving line of credit, such as a credit card, to the mix could help your score.
You can get a card even if you don't want to use it much. Just sign up to have one streaming service paid with the card each month and set up autopay for that amount. That way, you won't risk going into debt, but will still get the benefit of having a different type of credit on your record.
5. Applying for new ones can lead to inquiries on your credit record
Finally, each time you request new credit, you get an inquiry that stays on your record for up to two years. And the number of inquiries you have makes up 10% of your FICO® Score. Too many is bad news, as it suggests to lenders you could be going on a borrowing (and spending) spree.
Try not to apply for multiple cards within a short period of time. If you want a new card every couple of years that offers better perks or rewards, you can and should do that -- but applying for several at a time isn't a good idea. Nor is applying for a new card right before you try to get a big loan like a mortgage or car loan.
As you can see, credit cards could help or hurt your credit score, depending on how you use them. Focus on keeping charges low, paying off your balances every month, and not opening new accounts very often.
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