How do credit cards affect your credit score?

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Credit cards and your credit scoreYour credit score - that, single, all-important number - has an enormous impact on your financial future.

But too many people don't understand how this number is formulated or how their actions will help or hurt their score, especially when it comes to credit cards. According to the U.S. Census Bureau, just more than 70 percent of Americans have a credit card, and the average person has more than $4,700 in credit card debt.

These figures show that we are a nation struggling to use credit wisely. For consumers to get to this point, they must understand how every downward swipe affects their creditworthiness. Here's a primer on how credit cards affect your credit score:

Understanding your credit score

Your credit score, often referred to as your FICO Score, is comprised of several components: Your payment history (35 percent); current debts (30 percent); length of your credit history (15 percent); new credit applications (10 percent); and your credit mix (10 percent), or the varied accounts you have, including credit cards, loans, retail accounts or a mortgage.

Credit utilization - or the amount of available credit you have compared to what you've used - also impacts your score. For example, if you have $50,000 in available credit spread across five credit cards, but you've nearly maxed out all those cards, your credit utilization is high and that will ding your score.

To ensure your credit score is maximized, the best thing you can do is get a copy of your credit report. You are entitled to a free report each year from each of the three major credit bureaus (TransUnion, Experian and Equifax). Once you review your report, you'll have a better idea of how credit cards are impacting your score. Too much credit card debt, not paying your bills on time and opening new accounts all could hurt your score, so examine the report for these trends and craft a plan to address them - either by paying down debt, setting up automatic payments or by relying on one main credit card rather than multiple accounts.

How does applying for a credit card affect your credit score

New credit applications account for 10 percent of your credit score, but it's important to know that applying for one single credit card won't affect your rating in any meaningful way.

There's no real way to gauge exactly how much of a hit your credit score will take if you apply for one card because the exact methods for how FICO scores are calculated are a mystery to most of the consumer credit market. Nobody, except perhaps a few select people at the credit bureaus, know exactly how much a credit score is affected by applying for one solitary card. But honestly, it isn't much.

The problem comes about when you start applying for multiple credit cards in a short period of time. To the credit bureaus, it starts to look as if you're in financial trouble if you suddenly appear to want, say, six credit cards. If at about the same time, you try to get a loan for a house or car, even if your score doesn't go down much, a lender may look at your recent streak of applying for multiple credit cards and get very, very nervous.

Why? The lender has to allow for the possibility that you'll max them all out because you're short on cash. And if you have financial trouble, will you be able to pay off the new loan or will your cash be going toward all these credit cards? Therefore, applying for multiple cards in a short time frame can cause your credit score to take a hit or cause a lender to deny you a loan despite a robust credit score.

It's a bit unfair because you may have some perfectly good reasons for wanting more credit cards at once - for example, you feel that it's time you got a gas card, and it just so happens that you recently opened up a restaurant and need a good business card and you plan to stretch your income with a rewards card, and so on. You may easily be able to pay everything back, but if your behavior imitates some of the worst behaviors out there, bureaus and lenders may just assume the worst.

How comparison shopping affects your credit score

Before you apply for a credit card, it's a good idea to shop around. Simply browsing online credit card offers won't hurt your credit score if you're just window shopping and deciding what's most important to you - the biggest rewards or the lowest interest rate.

However, actually filling out an application and turning it in? That can affect your credit score.

Here's why: When you apply for a credit card, you're applying for a line of credit. Too many new lines of credit can bring down your credit score and negatively affect your ability to get additional credit. In other words, the more cards you apply for in a short period of time, the less likely you are to be approved. Applying for a credit card isn't something you should do lightly. You're really announcing your intention to draw on the new line of credit. If you do obtain a new card and then decide you don't want it, you can simply cut it up and not use it. You shouldn't necessarily cancel the card right away as your length of credit history does impact your credit score (more on this below).

Another way applying for multiple credit cards hurts you is that it results in new credit inquiries. Inquiries on your credit report fall into two broad categories:

  • A "soft pull" happens when a company you're already dealing with wants to pre-qualify you for a new credit card, a credit line increase on an existing account or another kind of business proposal. Because they're initiating the inquiry without your specific request, soft pulls don't impact your credit score.

  • A "hard pull" happens when you apply for a new credit card, personal line of credit, mortgage or auto loan. Some other financial services can result in hard pulls, like certain insurance policies or student loan requests. These inquiries do impact your credit score since you've initiated them for, in theory, a new line of credit or some other reason likely to impact your financial situation.

Banks and credit bureaus use a variety of credit-scoring algorithms, so activity on your account could cause a score from one source to stay about the same, while another source reports a significant drop. In general, the following ground rules apply:

  • Credit scores include a grace period for "rate shopping" on major secured loans. For instance, when you're looking for a home or a new car, consolidate all of your applications and pre-qualification requests into a two-week period.

  • On the other hand, credit cards and other unsecured lines of credit count as separate requests against your credit score. A credit reporting agency doesn't know whether you're replying for a balance transfer offer or attempting to increase your overall credit, so scoring models interpret both actions the same way.

Activity across all of your accounts helps determine the impact of a hard pull on your credit score. If you're making regular monthly minimum payments across all of your open accounts and your credit utilization remains low, a single hard pull won't cause much impact. You might only notice a drop of a point or two, and even that will go away after you open your new account. You'll feel a more profound drop if you've maxed out any of your cards or if you're running behind. Banks could see applying for a new line of credit as a sign of heightened risk. And multiple hard pulls over the course of a few months could seriously squeeze your score - banks could assume that you're trying to rack up new debt because of unemployment or illness, even if you're just trying to consolidate your existing balances.

Therefore, time your credit card applications wisely. Remember that instant-approval credit card offers almost always result in hard pulls that can drop your score. Compare credit card deals online, then apply for the best account you can find at a time when a temporary dip in your score won't impact your home loan rate, your insurance premium or your employment prospects.

What about too many credit cards?

Too many credit cards, or too many of the same kind of credit card, can pull dozens of points from your FICO score. New credit scoring models from the major credit reporting agencies can penalize you even more for having too many accounts.

The complex recipe for a high credit score involves managing the right mix of different types of credit cards and other personal credit accounts. According to FICO, the company that helped invent some of the most popular consumer credit scoring models, a high credit score reflects well-maintained accounts from these five categories:

  1. Credit cards

  2. Retail accounts

  3. Installment loans

  4. Mortgages

  5. Consumer finance accounts (car loans, for example)

The right blend of debt can account for as much as 10 percent of your credit score. Even though FICO and other scoring agencies don't explicitly penalize you for having too many credit cards, multiple accounts can leave you vulnerable to losing points in a few ways:

  • Too many new accounts. As we previously mentioned, saying "yes" to every credit card offer online or at the checkout counter makes banks nervous that you'll eventually overextend yourself.

  • Trouble keeping track of all your credit cards. Staying on top of a dozen different due dates can tax your brain power - and your wallet. Missed payments directly impact your credit score, and it's easy to lose a statement or forget a deadline when you're juggling too many bills.

  • Accounts show too little activity. You might consider yourself a big game hunter of credit card deals, but banks may start to wonder why you're hoarding accounts you don't use.

  • Lack of bank loyalty. Lenders hope you'll stay with them for a long time, so credit scores reward consumers who exhibit long-term commitments to the same banks. Having lots of lenders on your credit report actually ends up hurting more than helping your credit score, even if you've managed your debt responsibly.

Remember that you can use changes in your credit score to your advantage. For instance, a great balance transfer credit card offer does you the most good when you're more than a year away from making a change to your housing or insurance situations. Achieving great credit utilization and routine account activity can help you offset the damage from having too many credit cards.

How to maintain a good credit score

You can maintain a solid credit score by being smart about your credit card usage. First, limit the amount of credit cards you apply for and the amount of accounts you open. Some consumers get in trouble when it comes to retail accounts, especially. They open multiple store credit cards just to take advantage of that day's discount offer. Don't fall into that trap. Stick to retail card accounts for your favorite stores or avoid them altogether.

Always pay your credit card bill on time and, if you're able, in full every month. Using too much of your available credit will leave you with a high credit utilization ratio, and that will hurt your score. Try to pay off debt as fast as possible, either by transferring high-interest rate credit card debt to a card with a lower interest rate or by cutting back expenses or earning more income to pay off debt faster. Another important thing to note: Never close any long-term accounts, as the length of your credit history accounts for 15 percent of your overall score. Instead, pay down the balance on your credit cards and leave the accounts open. You can cut up the cards to reduce the temptation to use them or you can save them for smaller expenses every so often so these accounts remain active.

Credit cards are a valuable financial tool that can boost your credit score if you make consistent on-time payments and don't carry multiple accounts with high balances. However, they can be an albatross around your neck and impact your creditworthiness if you don't leverage them properly. Don't fall into the latter category - your financial future will be all the better for it.


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