A Beginner's Guide to Building Healthy Credit

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Your credit is one of the most important assets that you have. Healthy credit makes it easier to borrow money and get approved for the best rewards credit cards. It also gives you access to the lowest interest rates on loans—which can save you many thousands of dollars over your lifetime.

Many people assume that opening new credit cards and maximizing rewards isn't compatible with building healthy credit. But, that simply isn't true. In this post, we’ll explain the factors that impact your credit score and show you how to maintain and improve your credit health.

Why Healthy Credit is Essential for Earning Points & Miles

Over the past few decades, banks in the United States have become increasingly active in the travel-rewards ecosystem. Banks spend billions of dollars to purchase points and miles from loyalty programs. Then, banks use these points to attract new customers and incentivize them to use their cards. You can learn more in our post on building a healthy relationship with the banks.

For those based in the U.S., many of the best opportunities to earn points and miles are tied to rewards credit cards. If you have healthy credit, you can get approved for the best cards that offer huge sign-up bonuses and valuable rewards for your everyday spending.

Related: How Does a Credit Card Signup Bonus Work?

These cards also come with a huge range of travel benefits like airport lounge access, automatic elite status, free hotel nights, and complimentary travel insurance.

Related: 21 Credit Card Benefits Every Traveler Should Know About

In short, rewards cards open up a world of opportunity to those that take care of their credit. So let's take a look at the basics and chart your course towards healthy credit.

5 Quick Tips for Healthy Credit

If you’re looking for the short version of this article, following these 5 quick tips will keep you on the right path:

  1. Always Pay Your Account on Time — The single most important factor in managing your credit score is paying your accounts on time. Automatic payments (at least for the minimum balance due) can ensure you never hurt your score with a late payment.
  2. Keep Credit Utilization Under 30% — Banks get nervous when you approach your spending limit. Use less than 30% of your available credit whenever possible. If you can get your utilization under 10%, you'll likely see further improvement. So, you may want to proactively pay down your balances before applying for new credit.
  3. Don’t Close Your Oldest Accounts — Older accounts give lenders a better picture of your credit history, and they can help your score significantly. Do your best to keep them open and in good standing.
  4. Space Out Your Applications for Credit — Each time a lender checks your credit, the inquiry (known as a “hard pull”) will cause a temporary and small decrease in your score. Avoid opening too many accounts in a short time to minimize the damage.
  5. Maintain a Mix of Different Types of Credit — Lenders like to see a mix of different types of accounts, including credit cards, auto loans, mortgages, etc. More diversity in your credit mix gives lenders confidence you'll handle new credit like a pro.

Meet the Credit Bureaus

The credit bureaus are companies that track your credit history. Each bureau builds its own report that can be used to generate a score when requested by a bank or other lender. Because each bureau independently collects your credit information, your credit reports won't always be identical. Plus, mistakes can happen. So, it's a good idea to keep an eye on your report from all three credit bureaus:

Each of these companies will be happy to sell you an expensive subscription to credit monitoring. However, you can get much of the same information for free by signing up for Credit Karma.

Types of Score: VantageScore vs. FICO Scoring Models

The most commonly used credit score is FICO, created by the Fair Isaac Corporation. FICO generates a score for each of the 3 credit bureaus. Most of the major banks now offer access to your FICO score—although some require you to have a particular credit card to get this benefit.

While these services are handy to check your score, we still recommend signing up for a service such as Credit Karma, since they provide additional tools and a broader picture of your financial situation with data from your credit reports.

VantageScore is a competitor that is becoming more popular with banks. VantageScore was first created in 2006 by the three credit bureaus (Transunion, Equifax, and Experian). Like the FICO score, the current implementation of VantageScore goes from 300 to 850.

How Your Credit Score is Calculated

There are five main factors used to calculate your credit score. Both FICO and VantageScore use the same factors, though they weigh them differently. FICO gives percentages for how much weight is associated with each factor, while VantageScore just assigns relative importance.

Factors that go into computing your credit score

Payment History

Lenders are looking for customers that always pay their bills on time. Credit card interest is expensive, so we always recommend paying your full statement balance each month. However, this aspect of your credit score only cares whether you made at least the minimum payment on or before its due date. If you carry a balance over to the next month, that can affect your credit utilization—the next category we'll discuss—but it won't hurt your payment history.

If you are late, don't panic. Anything less than 30 days late shouldn't affect your score, but don't make a habit of it. A best practice is to set up automatic payments to transfer the amount due (or at least the minimum payment) from your checking account each month.

Amounts Owed (Credit Utilization)

Your credit utilization is defined as the amount of your available credit that you are currently using. If you have one credit card with a credit limit of $10,000 and you have a monthly statement balance of $5,000, then your credit utilization is 50% ($5,000 / $10,000).

Use less than 30% of your available credit whenever possible. If you can get your credit use under 10%, you'll likely see further improvement. The credit score calculation looks at both your total utilization across all revolving accounts and on each individual account. That means a 10% utilization on one card and a 95% utilization on another card can still hurt you.

It's worth noting that your amounts owed (and credit limits) are reported to the credit bureaus each month—typically when your statement closes. So even if you pay off your full statement balance on the due date, your credit report will reflect the percentage of your available credit you were using at the end of your billing cycle.

Age of Accounts (Length of Credit History)

Your average age of accounts is the third big factor in determining your credit score. FICO and VantageScore look at your oldest account, newest account, and an unweighted average age for all accounts on your credit report. The exact formula isn't known, but the conventional wisdom is that your oldest accounts (and especially THE oldest account) are most important for this metric, which makes up 15% of your FICO score and is rated as “highly influential” by VantageScore.

Older accounts with a long history of on-time payments and responsible credit utilization give lenders better insight into your behavior over time. A new account with three months of history isn't likely to predict future risk, but a seven-year-old account should inspire a lot more confidence. This is why it's so important to keep old accounts open and in good standing.

New Credit

When you apply for a loan or credit card, the lender requests a copy of your credit report from one or more of the three credit bureaus. This credit check (also known as an “inquiry” or “hard pull”) is added to your report for two years.

Your credit score will decrease a small amount—typically 2-5 points—with each inquiry. The effect can be greater when multiple new credit inquiries are added in quick succession, particularly if you don’t have a long credit history. Fortunately, new credit is a small part of your score overall, and the impact of credit inquiries start to fade almost immediately.

Credit Mix

This takes into account your entire lending mix, including items such as credit cards, personal loans, finance accounts, mortgages, and external factors such as being a guarantor or authorized user on another account.

Lenders like to see that you can manage more than one type of credit. If you can manage a mortgage, car payment, and multiple revolving credit-card accounts, you look less risky to a mortgage lender than someone who only has credit-card accounts on their credit report.

How Does Opening Credit Cards Affect My Credit Score?

Many people assume that opening a new credit card will hurt their credit score. In some cases, this can be true, but there are both positive and negative factors at play. If the positive outweighs the negative, you may see a significant increase in your score after opening a new account.

So let's take a look at how the factors listed above can be impacted when you decide to add a new credit card to your wallet.

The impacts on your credit score from opening a new credit card

A Negative Impact on New Credit

When you apply for a card, the bank will pull your credit report from one (or more) of the three credit bureaus. This credit check—also known as a ‘hard inquiry' or ‘hard pull'—will be added to your credit report. This falls into the “New Credit” category which is 10% of your FICO score (and “less influential” for VantageScore).

A hard inquiry will stay on your credit report for two years, but its effects will lessen over time. According to Experian, in most cases, new inquiries stop hurting your credit report after a few months. This factor takes effect when you apply for the card—regardless of whether you get approved.

A Negative Impact on Age of Accounts

When you open a new card, the average age of the accounts on your credit report will be reduced. However, the degree to which this affects your score depends on the rest of your credit history. If you have lots of other accounts with a long history, a new credit card may barely change your average age of accounts. On the other hand, if this is only your second credit card, the new account could cut your average in half.

Age of accounts makes up 15% of your FICO score and is rated as “highly influential” by VantageScore. This factor is more important than new credit, and the impact will last longer. Still, it's a relatively small part of your overall credit score.

A Positive Impact on Amounts Owed (Credit Utilization)

Credit utilization is calculated as the percentage of your available credit that you are using. When you're approved for a new card, you'll also get a new line of credit. If your spending stays constant, the additional credit reduces your utilization and should improve your score.

Like with age of accounts, the magnitude of this impact depends on the rest of your credit file. A person with lots of credit won't see a very big change in utilization.

Utilization is twice as important to your FICO score as your average age of accounts—which is why many people see their credit improve after opening a new card. VantageScore considers both to be “highly influential” but there is still a good chance that this positive factor will outweigh the negatives.

Credit utilization is a big reason why opening cards (and keeping them open over time) can increase your credit score. The more credit you have at your disposal the lower your utilization and the less risky you look.

A Positive Impact on Credit Mix

There is one additional factor that might come into play. Credit mix makes up 10% of your FICO score (rated “less influential” by VantageScore). If you don't already have other credit cards, opening a new one can add to the diversity of your credit report. Banks like to see that you can manage different types of credit. So your first or second credit card may have a modest, positive impact on this factor.

How Does Closing Credit Cards Affect My Credit Score?

There are many valid reasons to close a credit card, such as avoiding paying the annual fee or simplifying your wallet. However, most of the impacts that closing a credit card has on your actual credit score are negative, though thankfully fairly minor.

The impacts on your credit score from closing a credit card

A Negative Impact on Credit Utilization

Closing a card usually means giving up your line of credit. If the account you close makes up a small percentage of your total available credit, the impact on your utilization should be relatively small. However, this can be a major factor if you don't have other significant lines of credit. Check out the next section for suggestions on how to minimize this impact.

A Negative Impact on Length of Credit History

Closed accounts don’t get any older, so this card will no longer be helping to anchor your average account age. If you close one of your older accounts, you may significantly reduce the average age of the accounts on your credit report. However, the timing of this impact depends on the credit scoring model being used to generate a credit score.

Closed accounts (along with their payment history) stay on your history for 7-10 years from the date of closure. The FICO score considers the age of both open and closed accounts for as long as they remain on your credit report. That means the length of your credit history won't be affected right away by closing a card.

We weren't able to find a definitive answer from VantageScore about how closed accounts factor into your score. Most sources say that VantageScore considers closed accounts when calculating your age of accounts.

When the account drops off eventually, you may see a small score impact due to a change in your average age of accounts.

Avoid Negative Impacts When Closing a Card

There are a few ways to limit the negative effects of closing a card. One option is to consider downgrading to a no-fee card to preserve your age of account and credit limit. When you downgrade a card (also known as a product change), the account history is normally preserved. Your bank will mail you a new card—and hopefully refund that annual fee—but the credit bureaus will treat the converted account as a continuation of the old one.

It's worth noting that this doesn't always work. As a general rule, your age of account won't be affected if you keep the same credit card number through the transition. If your bank says your account number will change when you downgrade your card, the credit bureaus may treat this as a new account with respect to your age of accounts.

If you decide you want to close an account instead of product-changing to a different card, you may be able to move your line of credit to another account with the same bank. This preserves your total available credit. If your spending stays constant, closing that card won't hurt your overall credit utilization.

Final Thoughts

Credit might not be the most fun topic, but it's essential to maximizing your opportunities with points and miles. Healthy credit will open the door to the best rewards cards—offering lucrative signup bonuses and access to benefits that make travel more enjoyable.

Even if you decide to take a casual approach to points and miles, healthy credit will give you access to the best interest rates when it's time to purchase a home or car—which can save you thousands of dollars over your lifetime.

Did you learn anything new about credit scores? Let us know in the comments!

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Comments

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    This is an article that many people should read. I have approximately 20 cards and almost a maximum credit score. I have no other debt and I’m not going to take any on just to improve it.
    I actually didn’t realize that different types of credit were important, but once your score is over 800, it probably doesn’t matter.

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    Really helpful article! I was planning to close one of my cards, mainly because I was not using it. But thanks to this post I learnt it is better to downgrade to a no-fee card. And with this I preserved my credit limit, something I was going to lose without realizing if I had not read this article. MANY THANKS!!

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    I enjoyed reading this article, it’s been quite informative. My husband is a points and miles fan, and he got me started on my credit “journey” with the Capital One Quicksilver. It’s nice to earn something back for purchases I was making all the time anyway with debit and cash. I’ll be sure to refer back to this article from time to time for a refresher on how to maximize my credit score. Thanks!

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    Once I started paying off my credit card balance just about every day, my credit score really took off – avoiding a balance where possible when my statement closed really helped bump up my score.

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    It’s not just cards that are considered when calculating the age of your oldest account. I found that out the hard way when I paid off my first student loan; I thought I would see my credit go up a bit since I paid off a large loan, but instead it dipped for about 6 months because it registered as a closed account.

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    In addition, some employers check your credit history to find out how “responsible” you have been handling your finances in the past, in an effort to judge whether you are a good candidate

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    I noticed that my score has dropped more than expected after opening a couple of new cards recently. Now I see that it’s probably because of the average age of accounts going down! I did not realize that category was highly influential. Is there a target credit score that one should be careful to stay above to be able to be approved for the best credit cards?

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      It depends on the bank/card issuer, the particular card, and even the economy! But, a credit score of over 700 is generally best for the best rewards cards. The good news is that you’ll recover most of the credit score hit in the next couple of months.

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    How would the credit score be affected if one maxes out the credit allowance frequently but always pays the balance in full?

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    Nice breakdown, especially for those stumbling into this “game” and those who need a refresher.

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    Found this article very helpful, thanks

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    Useful article, young adults should be taught this.

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    Interesting article, very detailed and easy to read.