Won’t This Hurt My Credit Score?
Credit Score 101
One of the biggest myths I hear surrounding credit cards is they will hurt your credit score. This has elements of truth to it but in the end, the benefits outweigh any negatives. This will serve as a tutorial on your credit score and how using credit cards can actually improve your score.
Credit Reporting Agencies
There are 3 major credit reporting agencies: Experian, Equifax, and TransUnion. These agencies receive reports on your basic info, debt producing accounts (real estate loans, installment loans, revolving credit accounts), and public records. They also track how many times creditors have looked up your info (hard inquiries). All of this compiled information makes up your credit report and it is generally the same between all 3 agencies. I pull my credit report every morning through a subscription service with Experian just to hedge against identity theft and to track credit card longevity (this will become important in another article).
Your credit report is not the same as your credit score and in fact, the credit agencies do not give you your score. A credit score is calculated using your credit report by a 3rd party that uses proprietary scoring metrics. The most widely used scoring system is the FICO score and even within FICO, there are multiple different scoring metrics for various situations. If you are applying for a credit card, chances are the bank will get your FICO 8 score, which weights credit card history more than other metrics.
Becoming popular with banks that advertise free credit scores with accounts is the VantageScore 3.0, which attempts to mimic the FICO as much as it can but will typically be off 20 or so points in either direction. It is a good generalization of what your FICO score looks like but it is not the score creditors will see. It has come to be referred to as your FAKO score in credit rewards circles.
Effects of Opening a Credit Card
These scores all track generally the same main categories in your credit report to come up with an overall score: Credit Utilization (credit to debt ratio), Payment History, Derogatory Marks, Average Age of Accounts (AAoA), and Inquiries. The first 3 have the most significant impact on your score, AAoA has a moderate impact, and Inquiries have just a small impact. The three that opening credit cards have an effect on are Credit Utilization, AAoA, and Inquiries.
First, the negatives. Opening a credit card will hurt your score in two ways: it will drop your AAoA since you will be starting a new account at 1 month of history and it will come with a hard inquiry from the bank to receive your credit report. The effect of AAoA is unique to each individual depending on how much credit history you already have. Again, it will be a moderate impact on your score, however, it will start to improve with age as the length of history of that new card grows.
The hard inquiry will drop your score anywhere from 3-5 points initially, less after 3 months, and then stop having an effect at 1 year. They fall off your report totally at 2 years. Hard inquiries come whenever you seek out new credit (loans, credit cards, some utilities when you start their services, etc). Soft inquiries have no effect on your score and happen when you pull your own report or your report is pulled from advertisers to preapprove you for credit products.
That leaves credit utilization or credit to debt ratio. This is your moneymaker for your credit score. Credit utilization is a calculation of all the debt you currently hold in revolving accounts (credit cards as opposed to loans) vs all the credit that has been extended to you across all those accounts. This is a very easy-to-manipulate metric and has one of the highest impacts on your score. Generally, this will positively affect your score if it’s under 10% and it will keep improving down to 0%.
Let’s run some numbers to illustrate how this works. Say you have 1 credit card right now and that card has a $2k limit. You spend $1k per month on that card. Even if you are being a smart credit card holder and paying that card off in full every month, you are still at a 50% utilization ratio ($1k in debt/$2k in credit). This is majorly hurting your credit score even though you are doing everything right. There are two ways to improve that percentage, either lower your debt or raise your credit. You are paying off your card every month so you don’t really have debt to lower. You could stop using your credit card but that would go against all this blog stands for and you become a cash/debit person.
On the other hand, you could open a new credit card because you are a great American. Let’s say you do and because of this blog, you decide to go with the Chase Sapphire Reserve (CSR), our recommended card to start with. Chase is a generous bank and extends to you an $8k credit limit. You now have $10k total credit ($2k from your first card and $8k from the CSR) but your spending month to month remains at $1k. You’ve just dropped your credit to debt ratio to 10% ($1k debt/$10k in credit) and significantly improved your score, more so than the negative effects from the hard inquiry and AAoA. Generally, you will see this effect each time you get a new credit card.
There you have it. Credit cards, if used properly, will actually increase your credit score both initially and over the long term. The rest is up to you to be diligent with paying your statements in full every month and maintaining your current levels of spending.
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