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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. If you build healthy credit, you also can 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 hurts their 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 You Must Build Healthy Credit for Earning Points & Miles
- 5 Quick Tips to Build Healthy Credit
- Meet the Credit Bureaus
- Types of Credit Scores: VantageScore vs. FICO Scoring Models
- How Your Credit Score is Calculated
- How Does Opening Credit Cards Affect My Credit Score?
- How Does Closing Credit Cards Affect My Credit Score?
- Avoid Negative Impacts When Closing a Card
- Final Thoughts
Why You Must Build Healthy Credit 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.
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 — which offer huge sign-up bonuses and valuable rewards for your everyday spending.
In short, rewards cards open up a world of opportunities to those who build healthy credit, so let's take a look at the basics and chart your course toward healthy credit.
5 Quick Tips to Build Healthy Credit
If you’re looking for the short version of this article, following these five quick tips will keep you on the right path:
- Always pay your account on time. The most important factor in managing your credit score is paying your accounts on time. Automatic payments (covering at least the minimum payment required) can ensure you never hurt your score with a late payment.
- Keep credit utilization under 30%. Banks get nervous when you approach your card's 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 to your credit score. Proactively paying down your balances before applying for a new credit line can make your credit look even healthier.
- Don’t close your oldest accounts. Older accounts give lenders a better picture of your credit history, significantly helping your score. Do your best to keep them open and in good standing since credit age is an important factor.
- Space out your applications for credit. Whenever a lender checks your credit, the inquiry (known as a “hard pull”) will cause a temporary and small decrease in your credit score. Avoid opening too many accounts in a short time to minimize the damage.
- 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
Credit bureaus are companies that track your credit history. Each bureau builds its own report, providing the basis for a credit 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 monitor your report from all three credit bureaus:
Each of these companies will sell you an expensive subscription to credit monitoring. However, you can get much of the same information for free at Credit Karma.
Types of Credit Scores: 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 three credit bureaus mentioned above. Numerous 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 for checking your score, we still recommend using a service like Credit Karma to get additional tools and a broader picture of your financial situation through data from your credit reports. Credit Karma provides you with your VantageScore.
VantageScore is a FICO competitor that's gaining popularity. It was first created in 2006 by the three credit bureaus (TransUnion, Equifax, and Experian).
Both FICO and VantageScore use a range of 300–850 for credit scores.
How Your Credit Score is Calculated
FICO and VantageScore use the same five factors to calculate your credit score, though they weigh them differently. FICO gives percentages for how much weight is associated with each factor. VantageScore assigns relative importance instead. Understanding which factors are most important can help you focus on those as you build healthy credit.
Lenders want customers who pay their bills on time. This factor only considers whether you made the minimum payments each month. We recommend going beyond that, though. If you don't pay your full credit card balance each month, you will pay interest — which is expensive and eats up the value of your rewards.
If you make a late payment, 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 (covering at least the minimum payment).
Amounts Owed (Credit Utilization)
Your credit utilization is 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 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, but using less than 10% is even better. Your credit score will consider your total utilization across all 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. Even if you pay off your full statement balance on the due date, your credit report will reflect the utilization rate at the end of your billing cycle. Making a partial payment before your statement closes will lower your credit utilization at statement closing. Then, the credit bureaus will see a lower utilization rate.
Age of Accounts (Length of Credit History)
Your average age of accounts considers your oldest account, newest account, and an unweighted average age for all accounts on your credit report. The exact formula isn't known. Conventional wisdom, though, 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 brand-new account isn't likely to predict future risk, but a seven-year-old account should inspire more confidence. Thus, it's important to keep old accounts open and in good standing. If you have an old card that you don't use much, it's a good idea to use it at least twice a year so the bank won't close it since that would likely bring down your average age of accounts.
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 less than five 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 starts to fade almost immediately. It's also offset by other factors that carry more weight.
This factor considers your entire lending mix, including 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 multiple types of credit. If you can manage a mortgage, car payment, and multiple credit cards (known as revolving 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 and avoid cards while trying to build healthy credit. In the short run, this can be true due to the new inquiry and likely decreasing your average age of accounts. However, 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.
Let's look at how these factors can be impacted when you apply for 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) credit bureau. This falls into the “New Credit” category, which is 10% of your FICO score and “less influential” for VantageScore. This factor takes effect when you apply for the card — regardless of whether you get approved.
A hard inquiry will stay on your credit report for two years, but its effects decrease over time. According to Experian, new inquiries typically stop hurting your credit report after a few months.
A Negative Impact on Age of Accounts
When you open a new card, the average age of the accounts on your credit report is 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 age in half.
This factor accounts for 15% of your FICO score and is rated as “highly influential” by VantageScore — more important than the “new credit” category, and the impact will last longer, though it's a relatively small part of your overall credit score.
A Positive Impact on Amounts Owed (Credit Utilization)
Credit utilization is the percentage of your available credit that you are using. When you're approved for a new card, you'll get a new line of credit. If your spending stays constant, the additional credit reduces your utilization and should improve your score.
As with the 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 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 “highly influential,” but it's still possible that this positive factor will outweigh the negatives.
Credit utilization is a big reason opening cards (and keeping them open over time) can increase your credit score. The more available credit you have, the lower your utilization — assuming your spending doesn't go up. Low utilization makes you look less risky.
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 and is 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 portfolio. 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 not wanting to pay the annual fee or simplifying your wallet. Most of the credit impacts from closing a credit card are negative — though thankfully they're minor.
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 or are closing a card with a large credit line.
We'll discuss how to negate this below.
A Negative Impact on Length of Credit History
Closed accounts don’t get any older, so this card won't mature and help 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 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 your length of credit history won't be affected immediately when closing a card.
VantageScore doesn't provide definitive information on 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. However, this won't drastically affect your efforts to build healthy credit and a good credit score.
Avoid Negative Impacts When Closing a Card
It's possible to limit the negative effects of closing a card. One option is to consider downgrading to a no-annual-fee card to preserve the age of the account and credit limit. When you downgrade a card (also known as a product change), the account history is normally preserved. Your bank may 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. Be sure to ask your bank during the product change process.
If you decide to close an account, 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.
It's not fun learning and reading about how to build healthy credit, but it's essential for 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 take a casual approach to points and miles — or don't participate at all — healthy credit is important. It provides access to the best interest rates when purchasing a home or car. This can provide thousands of dollars in savings over your lifetime.
Did you learn anything new about credit scores? Let us know in the comments!
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