To the untrained eye, it might seem that debit or prepaid cards are a smarter way to pay than credit cards. Since they don’t involve borrowing money, there’s no way to get into debt. However, credit cards serve a purpose beyond stacking up debt.
Using Borrowed Money Is Essential to Building Credit
Before you shred all your credit cards, it is important to realize that using borrowed money responsibly is essential to building a strong credit score, which will allow you to receive favorable loan terms on mortgages and auto loans. Your credit score’s use doesn’t end there, as it can also help to reduce the cost of various types of insurance coverage. Many credit cards will also provide exceptional rewards at no real cost to the consumer (when used properly).
Regardless of whether you are a credit beginner or a seasoned veteran, the most effective way to improve (or destroy) your credit score is through the use of credit cards.
How To Use Credit Cards Effectively
- Pay your bill on time every month. No exceptions! On-time payments are one of the biggest factors in your credit score. This is calculated by dividing the number of payments made on time by the total number of payments due. As can be expected, the fewer payments in your credit history, the more a missed payment will impact your score. Seven for 10 might get you a spot on a baseball team, but it certainly won’t get you a mortgage. (For related reading, see: Credit Cards: Making Payments.)
- Pay off your credit card balance in full every month. Credit card interest rates can be high, some reaching 25% or more. Carrying a balance on a credit card with a high interest rate is not only a black hole of increasing debt, it can also be detrimental to your credit score. Additionally, be wary of 0% annual percentage rate (APR) offers that are toted by many credit card companies. This can often be a trap, and if you don’t pay off the balance before the promotion ends they generally tack on all the interest accumulated during that period. Not good.
- Keep your credit card balance below 30% of the total available credit line. Credit card utilization has a high impact on your credit score, so it is important to keep it as low as possible. For example, if your credit card balance is $500 out of a $1,000 limit, the credit utilization ratio is 50%. If you plan to make large purchases on your credit card, the best practice is to make an extra payment mid-month to ensure your utilization ratio stays below 30%. Another great way to reduce your utilization ratio is to periodically request a credit line increase. If you keep your balance the same, a higher credit limit will give you a lower utilization ratio. Usually these requests result in a credit inquiry by the financial institution, so try to only do this once every six months.
- Don’t close a credit card account simply because you aren’t using it. A portion of your credit score is derived from your number of open accounts and the amount of time they have been open. If you close a credit card account, you lose all the good stuff: credit limit, age of credit history, on-time payment history, etc. As luck would have it, all the bad stuff will stick around even if you close the account. So, feel free to cut up the credit card if you aren’t going to use it, but don’t close the account.
Using Credit Cards Wisely Will Help You Achieve Financial Goals
The use or misuse of credit cards can be incredibly important in helping you reach your life’s goals. It is imperative to establish the right habits early. While these tips will certainly get you started, there are many resources available online that can help as well. CreditKarma and WalletHub provide free credit monitoring as well as tools to help you improve and track your score. (For related reading, see: Top Places to Get a Free Credit Score or Report.)