How Credit Works

How Credit Works
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Image courtesy: Sean MacEntee
 

If you’ve spent some time browsing PointsAway, you’ve likely noticed that the most powerful way to obtain the points needed to make your travel dreams a reality is often through credit card sign-up bonuses.

Many people reflexively cringe at the prospect of a credit card application, because of some of the conventional wisdom – true and false – about credit cards and how credit works. Hopefully this primer can allay some of those fears and leave you better informed about a very critical component of your financial life!

Where Do Credit Scores Come From?

Although other providers exist, FICO is the company responsible for the credit score formula used in 90% of lending decisions in the US. FICO credit scores are on a scale from 300-850.

There are three major credit bureaus in the US: Experian, TransUnion and Equifax. Each of these credit bureaus calculate their scores using FICO’s algorithm based on the information they have about your credit history. That’s why scores can be somewhat different from each of the bureaus: they calculate scores the same way, but some may have more or less complete and more or less recent information about your credit history than others.

On the FICO scale, a credit score of 700 or above is considered good; above 720 would be very good. The average score in the US is roughly 692, and the median is roughly 723.

You’re entitled by law to view your credit scores as calculated by each of the three major bureaus once per year. AnnualCreditReport.com is where you want to go for this, as that is the official site where you can receive truly free reports from each bureau annually. You do not need to sign up for a credit monitoring tool or pay anything for these reports.

CreditSesame.com and CreditKarma.com are great tracking tools that can help you keep track of your credit score throughout the year. The scores calculated by each of these sites are estimates and are not your official score, but CreditSesame is operated with Experian data and CreditKarma with TransUnion data, so their estimates are based on the same information used by the bureaus in calculating your official FICO score.

How Are Credit Scores Calculated?

You surely know that your credit score plays a very important role in your ability to obtain a car or home loan, a new credit card or even sign up for utilities, television and phone service. But do you know how this score is calculated?
Your FICO score is based on five key components, each of which are more or less important as shown by the weighting they’re given in formulating your score.

PAYMENT HISTORY – 35%

Do you pay your bills on time and consistently? There’s no more important question in the mind of a creditor. Any delinquencies, collections activity, or other negative marks in this area will severely impact your score. Paying what you owe, when you owe it, is the foundation of your credit, and therefore your credit score.

CREDIT UTILIZATION – 30%

How much of your credit do you use, and how often? Let’s say you have just one credit card, and that it has a $5,000 limit. If you spend and/or carry a balance on this card at $4,000, you’re using 80% of your credit. Creditors actually want you to use only a fraction of the credit available to you. This indicates personal responsibility and restraint to creditors. Opinions differ on the optimal credit utilization rate, but they range from 10-40%. I personally believe 15% or less should be the goal. More on this later.

LENGTH OF HISTORY – 15%

This is the average age of your existing lines of credit. The longer the better here, as might be expected. After all, the longer you’ve been proven to pay your bills on time, the more likely it would appear you’ll continue to be good for your debts in the future.

NEW CREDIT ACCOUNTS – 10%

This is the portion of your score where recently opened credit lines and inquiries come into play. The thinking is, new accounts add a bit of risk to your credit profile, especially if you’ve made several moves in the recent past, such as a new car and home loan and several new credit cards. Credit inquiries – most typically tied to opening a new account – show up on your credit report for two years, but only the past year is used in calculating your score. Only hard inquiries count, or those that resulted in a new credit line of some sort. Soft inquiries, like those banks use to “pre-approve” you for card offers or auto loans, do not count against you.

TYPES OF CREDIT – 10%

Creditors like to see that you’re good for many different types of loans. Auto loans, home loans, utility bills, post-paid telecom services, credit cards, personal loans and many others make up the full spectrum of credit. The fuller picture of your creditworthiness, the better, in the eyes of creditors.

How Credit Card Applications May Affect Your Score

While every individual situation is different, my credit score actually increased by 25 points according to CreditKarma and by 31 points according to CreditSesame from January 2013 to July 2013, despite signing up for five new cards during that period of time. How can this be? After all, conventional wisdom holds that applying for credit cards hurts your credit.

The answer lies in the breakdown of how credit scores are calculated, shown above. Each credit card for which I was approved did indeed ding me by a few points on two of the components: New Credit Accounts and Length of History. However, both of these combined only make up 25% of a credit score. Each new account actually helped lower my utilization. If you spend $2,000 a month and have a limit of $5,000, you are using 40% of your credit. If you open a new account and now have a combined credit limit of $10,000 but still spend just $2,000 a month, you are now using only 20% of your credit.

In my case, I have a relatively limited credit history. My oldest credit card, a Chase Amazon.com Visa, was opened in August 2007. Because I had already opened a few new cards along the way before signing up for those five new cards this year, my Length Of History was only a couple years, already below average. I therefore didn’t have much to lose on this front.

There’s a diminishing negative effect to New Credit Accounts, as well. Only your last 12 months of hard inquiries are taken into account, and because it’s often wise to apply for multiple cards on the same day since inquiries take time to show up on your report, the negative impact is limited and goes away relatively quickly.

If you’re like me, the large benefit from improving Credit Utilization can outweigh the slight dings to these less important components.

Take a look at these real charts of my personal score from CreditKarma and CreditSesame as an example. I applied for and was approved for two new cards in January, two cards in March and one card in May. As you can see, my score did indeed decline slightly going into March based on these new inquiries, but this was also significantly affected by refinancing my home.

My score rebounded thereafter and is continuing to increase as the number of inquiries on my account in the past 12 months decreases, my average age of accounts increases and my credit utilization improved significantly from about 21% to 3% thanks to these new accounts.

Credit Cards Versus Charge Cards

With most credit cards, you can carry a balance, although the interest rates to do so are often quite steep. Charge cards, on the other hand, must be paid in full at the end of each billing period or you will incur significant penalties. American Express offers several credit cards today, but the company has traditionally focused its offerings on charge cards.

Charge cards do not have a set credit limit; the limit is soft and rises and falls based on your spending habits. Because of this, charge cards do not count toward the credit utilization component of your score. This means charge cards don’t benefit your credit score the way credit cards can as discussed in the previous section. That’s not to say they aren’t without benefits. Charge cards may be somewhat easier to obtain than credit cards from issuing banks because charge cards represent less risk by virtue of their full balance being due each month.

A Word on Business Cards

The many benefits of business credit cards, and how you may be eligible for one even if you don’t think so now, are discussed in detail here.

When applying for business cards, an inquiry will appear on your personal credit, but it will not typically be listed as one of your accounts on your credit score, and the credit limit will not apply toward your personal utilization number. Therefore, the impact of business cards on your personal credit report is less than that of personal cards.

Business cards are almost always personally guaranteed, though, so make no mistake: not paying down your business credit cards can negatively impact you just as profoundly as defaulting on your personal cards.

Credit Is A Resource

Your credit is a renewable resource, and that comes with great benefits and important responsibilities. Most important is to be good for your word, because that’s what your credit represents.

I highly recommend paying off your balances in full every month, and abstaining from any purchases that make this impossible. If you do carry a balance on your card related to a large purchase, do so responsibly and with a solid plan plotted out in advance of the purchase that allows you to pay it off quickly.

Don’t apply for an extreme number of credit cards at the same time, and don’t abuse your relationship with the banks that issue cards. If you sign up for a card, spend up to the minimum necessary to earn an introductory bonus and then cancel your card, the issuing bank is not likely to want to do business with you in the future. Choose cards that can help make your dream trip a reality and continue to provide you benefits well into the future.

Holding Multiple Cards

Keeping a portfolio of cards that offer extra points for different types of spending is a great reason to apply for multiple cards. For example, I love my Chase Sapphire Preferred and Ink Bold cards because of how they work together. Both earn Ultimate Rewards points, but Sapphire Preferred offers 2x points on travel and restaurant expenses, while Ink Bold offers 5x points at office supply stores and on telecom charges and 2x points at gas stations and hotels. Between just these two, I’m often earning multiple points for every dollar I spend.

Churning & Canceling Cards

It’s possible to “churn” cards by cancelling one and signing up for another in order to benefit from a new introductory bonus, but do so on a 12+ month basis and only for good reason, such as if your traveling habits shift from one airline or hotel to another.

If you don’t think a card is worth keeping once its annual fee comes due, call the issuing company and give them an opportunity to keep your business. They’ll often offer a reduced fee, waive it entirely, offer you bonus points in exchange for paying the fee, or offer to shift you to another card where you can continue earning points without paying the fee.

Be A Good Customer

Remember why these incredible sign up bonuses are offered in the first place: the issuing banks want to earn your business and keep it. It’s possible to be points savvy and also a good customer. Let this mentality guide your actions and you can enjoy incredible travel opportunities for years to come.

6 Comments
  1. Lena

    Well written and very easy to follow & understand. I’m new to Points & Miles and have recently started reading related blogs…so much to learn and wish I have known about traveling for pennies;). My husband and I love to travel and have done it the old fashion way…using our hard earned dollars, thus limiting our opportunities.

    I’m excited to explore this venue and look forward to many more travels.

    Thank you for inspiring us.

    • PointsAway

      So glad to have you here, Lena! Please let me know if you have any questions :)

  2. Lisa

    Hi there!
    Thanks for all of the info in your blog. I am still trying to understand the impact of canceling cards. I recently got into the acquiring points game and have a Starwood AMEX, Capital One Venture Card and two Chase business cards. Does it make sense to cancel any of these cards before the annual fee time comes? Or should I pay to maintain all of them?
    Thanks for your thoughts!

    • PointsAway

      Hi Lisa, great to hear from you! This is unfortunately one of those “It Depends” situations that will vary person by person. Depending on what type of travel you do, what kind of category bonuses you’re most likely to take advantage of and if there are any benefits associated with your cardmember anniversary, the answer may be different.

      I’d probably switch from Venture to the Arrival Card as I like Arrival’s program better and you can earn a new bonus.

      The SPG Amex may be worth keeping if you stay at SPG locations often or like their spending bonuses and transfer flexibility.

      The Chase cards depend on which ones you have. For example, you might consider switching from an Ink Plus to an Ink Bold or vice versa if that is one of your Chase business cards. If you have the Southwest biz card and travel on Southwest often, that might be worth keeping. You can always call the card companies as the date nears and try to negotiate a reduced or waived annual fee, a new spending challenge for bonus points or an anniversary bonus of additional points if one isn’t already offered with the card in question. There are definitely many possibilities, and we’ll cover these more fully in a future article! Thanks for reading!

      • Lisa

        Good idea! Is the Arrival Card also from Capital One?

        • PointsAway

          It’s from Barclaycard, actually. I like it better than the CapitalOne Venture because of the much more generous introductory offer and the 10% points rebate on all redemptions :)

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About PointsAway
Casey Ayers is a consultant and entrepreneur with a passion for travel. After amassing enough miles and points to travel anywhere in the world for almost free in less than six months, he developed PointsAway as a way to help others make travel dreams big and small come true.
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