The topic of how a credit card affects credit scores requires a three-part answer that matches the life cycle of any revolving account: when applying, using, and closing.
Each stage of the life cycle engages one or more important credit score factors.
The application stage impacts the new borrowing activity (10%) and payment history (35%) aspects. During the usage stage, the amounts owed (30%) comes into play. Finally, closing the account can trigger the length of history (15%) and amounts owed factors.
Follow this outline for insight on how a credit card may affect your score at your stage in the process.
Applying for New Credit Card Accounts
Applying for a new credit card can affect credit scores in both directions. In general, a new account hurts your ratings in the beginning and then helps them over time – provided you make your payments according to terms.
New borrowing activity makes up 10% of your rating.
A hard inquiry appears on at least one version of your consumer report and hurts your score for 30 to 60 days – at that one bureau. The hard inquiry appears only on the file of the agency providing the report (Equifax, or Experian, or TransUnion).
The hard inquiry tells the equations that you applied for a new credit card. This means that a new trade line with unknown terms could appear on your consumer report in 30 to 60 days – if approved.
If approved, opening a new credit card account hurts all three of your scores temporarily. The new trade line now appears on each of your consumer reports (Equifax, and Experian, and TransUnion).
The newly opened account introduces another uncertainty – whether you can handle the extra responsibility by making the required payments. The purpose of the card and the acquisition channel does not make a difference.
Making credit card payments on time builds your credit history and improves your score over time. Payment history makes up 35% of your rating. Therefore, your record over the next six months and longer is very important.
Establishing a history of on-time payment is a key building block for credit health.
Being 30 days late or worse on credit card payments lowers your score right away. Furthermore, the delinquency stays on your consumer report for 7 years and hurts your ratings until disappearing.
Removing correct negative information from your report is all but impossible. Therefore, make sure you can handle the account responsibly. Do not purchase want you cannot afford.
Opening a department store credit card does not affect your score in a unique way. The same factors (new activity and payment history) apply for a retail account as they would a general-purpose card issued by a bank.
Department store cards are a great way to establish a file and build a history of on-time payment. Retailers often have easier underwriting standards because they want shoppers buying more merchandise.
Pre-approved credit cards do not affect your score unless you respond to the offer. The furnishing bureau will log a soft inquiry for every consumer passing the criteria. This phase has no impact.
People who respond to the pre-approved offer set off a hard inquiry as the bank pulls a copy of your consumer report. If nothing has changed since the original screening the bank must agree to open the account.
Credit Card Debt Utilization Ratio
Your credit card debt utilization ratio also affects your credit score. The amounts owed make up 30% of your rating, so this factor is also very important. You calculate the debt utilization ratio as follows.
Total Revolving Balances/Total Revolving Limits
There is no ideal percentage, as each person’s profile differs. In addition, the equations weight the ratio differently for up to twelve distinct consumer groupings. Follow this general rule.
- Above 30% is bad
- Below 20% is good
This seemingly simple fraction causes great confusion around paying interest and making minimum payments. Also, knowing what to do when the ratio is too high or too low is not obvious.
Paying credit card interest does not affect your score directly. The banks do not report the interest charged or paid to the bureaus.
However, paying interest hurts your score indirectly. You pay interest on credit cards when you pay less than the full balance owed at the end of any billing cycle. This inflates the balance owed and increases the debt utilization ratio. This does lower your ratings.
Likewise making the credit card minimum payment does not affect your score directly. The banks do not report the amount paid each month to the bureaus. They report the balance owed at the end of each billing period.
However, making only the minimum payment hurts your score indirectly. Your balance will grow every month as you make additional purchases and the interest continues to accrue. This also inflates the debt utilization ratio, which does lower ratings.
Utilization Too High
A credit card debt utilization ratio that is too high will hurt your score. You have two options to lower a fraction when it is too high.
- Have the bank(s) increase the limit(s): boost the denominator
- Reduce the balance owed amount: shrink the numerator
The banks decide whether to grant a line increase. Meanwhile, you control when and how to reduce the balance – which is better. You can pay down, consolidate, or reach a settlement on the debt.
Paying down credit card debt is the best way to lower a high debt utilization ratio and increase your score. Using your own money to pay off the obligation takes sacrifice and persistence but rewards you in the end.
No one can tell you the number of points your score will increase. Too many other factors come into play. However, paying off debt using your own funds will never hurt your ratings as the next two options can.
It is difficult to consolidate credit card debt without hurting your score in the beginning. The first two steps of the process count against your rating before the debt utilization ratio drops. In addition, the total amount owed remains the same.
- A hard inquiry for the debt consolidation loan lowers ratings at one bureau
- The newly opened debt consolidation loan lowers ratings at all three bureaus
Settling credit card balances can lower your debt utilization ratio. However, it has a long-lasting negative effect on scores. Two steps in the settlement process make this a viable option only for people already behind on payments.
- You must stop paying all unsecured creditors in order to fund an escrow account and to display financial hardship. The delinquency displays on your report for 7 years.
- The final “Paid Settled” status will appear on your consumer report is a major derogatory mark. It stays on your file for 7 years counting from the date of first delinquency.
Utilization Too Low
A credit card debt utilization ratio that is too low does not hurt your score in the short-run but can over a longer period. Take for example a person with a 0% utilization. This person must do two things to get the percentage down to zero and keep it there.
- Pay the balance in full each month. This does not increase your ratings by itself. The bank will report the balance at the end of each billing cycle, which is always greater than zero if you keep making purchases.
- Stop making purchases. You will reach 0% utilization after two billing cycles complete.
However, two bad things can happen that could impact your ratio and score once you stop making charges.
- The bank may stop updating the bureaus. The equations may ignore these trade lines after six months of inactivity.
- The bank may cancel the account due to inactivity. The limit drops to zero and cancels out the zero balance.
Therefore, keep using your card so that the utilization ratio stays low – but always a positive number.
Closing Credit Card Accounts
Closing a credit card can hurt your credit score, but it can also help people who wish to avoid future delinquencies. Every person and situation is different. One size does not fit all.
You will find minor timing variations when canceling with a zero versus an outstanding balance.
Closing a credit card with a zero balance can hurt your score in the short run or help it in the longer term. Consider how three score factors respond when you close a revolving account that you paid in full and have not used for several months.
- The utilization ratio increases because the denominator is now smaller. You lost the benefit of the limit for at least one account right away (short-term).
- Your length of history remains the same. The closed account will still appear on your consumer report. Length of history makes up 15% of your rating.
- You will never be delinquent in the future (long-term). People who find it difficult to control spending often benefit by cutting up their plastic. Negative history stains your file for 7 years.
Closing a credit card with an outstanding balance has less of an impact on your score in the short-run. The reason is that the equations continue to count both the limit and balance in the utilization ratio calculation until the amount owed reaches zero.
After you pay the amount down completely your ratings respond as if you closed the account with a zero balance – see above.