Guide to Credit Cards: The Credit Rating Myth
Credit ratings are a source of worry and concern for millions of people. Your credit rating can determine whether you can get a loan or a mortgage, and at what interest rate.
But there's a lot of misunderstanding about credit ratings, particularly related to credit cards. Most people think that having more credit cards damages your credit rating. But that's far from clear. Here's why.
There are three credit rating agencies: Equifax, Experian and Trans Union. They all use the same method for calculating your credit rating, known as a FICO score, developed by Fair Isaac. The exact method of calculating your credit rating is kept secret, ostensibly to prevent consumers manipulating their credit ratings. But Fair Isaac has described the overall approach, and from that we know a certain amount about how credit ratings are calculated.
Factors used by the credit bureaus to determine your credit rating include:
1 Major derogatory items, including bankrupcy, collections, foreclosure and negotiated slow payment of debt.
2 Time at present job.
3 Time at present address.
4 Ratio of balances to available credit lines. The lower the better.
5 Number of recent credit inquiries, for example if you are applying for a mortgage.
6 Age. 50+ is the best.
7 Number of credit lines on your report.
8 How long you have had a credit line in the credit bureau database.
Three of these factors are impacted by credit cards. The number of cards you have feeds into the number of credit lines on your report. The length of time you've had a credit card for impacts the length of your credit history in the database. And the total credit available to you, minus your outstanding balances, impacts the ratio of balances to overall credit.
Note something interesting here. Having more credit cards negatively impacts your credit rating as it means that you have more lines of credit. But if more credit cards means you have more available but unused credit, that improves your score. And keeping old credit cards for long periods of time also improves your score.
The upshot?
Having more credit cards doesn't necessarily damage your credit score. In fact, it can actually improve it, as long as you don't apply for lots of cards in one shot (that generates too many credit enquiries) and you keep the total available credit to a reasonable amount.
Think carefully before you cancel old credit cards. Even if you don't plan to use them, keeping them active by charging the price of a coffee once a month will actually help your credit score.
Think before you consolidate your spending on to a single credit card. Doing so could raise the proportion of available credit you are using. Instead, try to make sure that the available credit you have is far greater than the amount you bill to your credit card each month.
Credit ratings matter for sensible loans - like mortgages. None of this should affect your resolve never to borrow money on your credit cards, as discussed earlier.
If credit ratings don't determine the number of credit cards you should use, what should? That's what we'll look at next.
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