How credit scores work
A credit score is a numerical representation of the probability of default of a loan or line of credit. In other words, it says how likely you are to pay your bills.
That is why credit scores are so useful for lenders and creditors. It tells them how much risk you have for default. That means they can make informed decisions about approval and set interest rates appropriately.
There are five main components that go into determining a credit score. These are:
- Payment history
- Credit utilization
- Length of credit history
- Credit mix
- New credit
The first entry has the biggest impact on your credit score: 35% of your score comes from your payment history. That means that a timely payment record will have the biggest impact on your score. It also means that late or late payments, collections and defaults will dramatically lower your score.
The second element is the use of credit. This category represents 30% of your credit score. Credit utilization refers to the amount of renewable credit you are using compared to the amount you have. Rotary credit is something like credit cards, where you have a line of credit that you use and then pay. Things like loans where you receive money in advance and then return it do not fall into this category.
If you have a credit card with a limit of $ 1,000 and have a balance of $ 100, then you are using 10% of your renewable credit. The lower your credit utilization, the better your credit score. This is because a low use of credit indicates that it currently does not face financial difficulties and that it uses credit responsibly.
The duration of your credit history represents 15% of your credit score. Your credit history is important because the more history credit reporting agencies have, the more accurately they can predict how likely you are to pay bills. That means you should not close accounts once you have paid them, as that could damage your score.
Your credit combination represents 10% of your credit score. This analyzes your ability to handle different types of credit. For example, car loans, student loans, credit cards and mortgages. The better your credit combination, the better your credit score.
Finally, the new credit represents 10% of your score. This includes inquiries or credit checks you get when you apply for a new credit. The more controls you have in your report, the lower your score. This is because applying for a new loan is a sign that you have money problems, which means that you have a higher risk of default.
It is also important to understand how the different entries in the credit report set up your score. Negative entries will expire from your report. Most things fall off your credit report after 7 years. The only exceptions are credit inquiries, which fall after 2 years, and liquidation bankruptcies, which remain in your report for 10 years.
In addition to falling after a period of time, the greater a negative entry, the less will be taken into account in your score. That means that not only is it possible to recover if you have a damaged credit history, but it will actually happen faster than you think.
It is also important to keep in mind that it takes some time to obtain a credit score. You must have six months of account history before you can get a FICO score. That means that if you don’t have a credit score, getting a credit card will not immediately set one for you.
How credit cards affect credit scores
Now that you understand better how credit scores work, it’s time to see how credit cards can affect your credit score.
Credit cards actually touch several of the categories that are included in your score. The impact on your payment history, credit usage, credit combination and credit history duration. That means that credit cards can have a big impact on your credit score.
The best way to generate credit with a credit card is to make regular payments, pay the full balance of your card and avoid closing accounts. It is surprisingly important to avoid closing accounts. This is because doing so reduces the duration of your history. It also reduces the amount of credit you have available. That means your credit utilization can increase if you have a balance.
Benefits and disadvantages of using credit cards to generate credit
This section covers the benefits and disadvantages of using credit cards to generate credit. Here is a lot of information, and it is important to understand the possible ways in which the use of a credit card can affect your credit before you have one to build your credit score.
There are four main benefits to using a credit card to build your credit history. They are:
- Credit card definitely reports payments
- Help with multiple aspects of the credit score
- Many options for credit cards
- Secured credit cards mean that anyone can get a
The first benefit is that credit card companies always report payments to credit reporting agencies. This is vital because companies are not required to report payments in most cases. That means you may not have any credit history, even if you have been paying utility bills and rent for years.
On the other hand, credit cards always inform. That means getting a credit card will ensure you have a payment history and increase the duration of your credit history.
In addition, a credit card touches multiple aspects of your credit score. Increase the amount of available credit, which can reduce its use. Payments on time will give you a good payment history, and keeping an account open and active will help increase the duration of your credit history. Finally, credit cards are an excellent way to add revolving credit to your credit combination so you can show that you can handle many different types of credit.
There are also many options for credit cards. That means you can choose the best card for you. You can get different rewards and benefits that improve your life. Cash back cards will make your purchases cheaper and save you money, and the best travel credit card can help you get the vacation of your dreams, and so on.
Finally, secured credit cards mean that anyone can get a credit card, even someone with a bad score or no history. A secured credit card works in a very simple way. You make a security deposit with the credit card company. The size of your deposit will be your credit limit. That protects the company from the credit card in case of default. Then, you can pay your card every month to build your credit history and score. Eventually, you can even convert your secured card into an unsecured card and recover your money.
There is no such thing as a free lunch. This adage also applies to credit cards. While there are several benefits to using a credit card to build your credit, there are also possible inconveniences. These inconveniences are:
- It can be difficult to qualify for a better credit card without credit
- The interest rates on the card can be high
- It requires good financial discipline to work
First, if you do not have a credit score or have a bad credit score, then you will have difficulty obtaining approval of the best credit cards in the market. That means you may not have access to things like cash back or travel rewards. Take a look at the best credit cards for bad credit.
Second, interest rates on credit cards can be very high. As a result, you can quickly find yourself building a credit card balance that costs you to pay. Once you leave a balance on a card, you will pay interest on any balance you have until everything is canceled. That can make you spend a lot of money to use a credit card for purchases.
Finally, if you want to accumulate credit with a credit card, you must have good financial discipline. Leaving a balance on your card will decrease your credit score, as it increases your credit usage. Also, if you accumulate a large balance, your payment will increase. That makes it harder to make your payments on time, which can damage your score.
A credit card can be a great source of debt if it is not used responsibly. Therefore, you should make sure to establish a budget that allows you to pay your credit card balance each month. You should not use your card to splurge purchases if you do not know how you will pay for them.
Responsibility is the key: do not let your credit card damage your credit score
In summary, the most important thing you should know about using a credit card to build your credit is that responsibility is key. After all, that’s what a credit score measures. If you pay your balance on time and avoid excessive expenses, a credit card can be a great way to accumulate credit. Otherwise, it could affect your credit score and generate debts.