How Credit Cards Build Credit

credit cards to build creditA person’s creditworthiness is one of the most important factors in getting a loan for a car, a home, or even a job. Your credit history affects auto insurance rates, interest rates on loans or credit cards and the ability to have financial options. Credit cards play a major role in building your credit history and credit score. Credit cards build credit in important ways such as establishing credit, creating a payment history, and establishing different types of credit accounts.

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Credit cards must be used in a responsible manner; you should pay the balance off as soon as possible. They should be used for emergencies or high-priced items that can be repaid quickly. Credit cards can build bad credit as well as good credit, and they can leave you with a mountain of growing debt.

Your Credit History

Every American has a credit history with various credit reporting bureaus. The big three that are most commonly used are TransUnion, Experian, and Equifax. These credit-reporting bureaus keep track of financial-related information such as loans, credit cards, and your payment histories. This money-related information is your credit history.

When a credit card company extends you credit, that goes on your credit history. The bureaus report how much credit you were given, called your credit limit, and they keep track of how much of that credit limit you have used.

They also keep track of payments that are on time and paid in full. This is true of all of your loans, lines of credit and other forms of credit.

Likewise, credit reporting bureaus also keep track of negative factors such as late or missed payments, reduced credit limits, and bills that have gone to a collection agency. This can create a bad credit history that could cause a denied credit card application.

Your Credit Score

The three major credit-reporting bureaus take all of your credit history, good and bad, and assign it a score. According to the site MyFICO.com, they use software developed by Fair Isaac Corporation to turn your credit history into a number that ranges from 300 to 850; because of this, credit scores are also called FICO scores. The higher your credit score, the more likely you are to be approved for the best interest rates. The software crunches the data along these percentages:

  • 35% of your score comes from your payment history. This includes how often your payments were late or on time, if you paid in full, and any accounts have gone to collection.
  • 30% of your score is the amount you owe. This shows how much of your credit you have used.
  • 15% is the length of your credit history. Accounts that have been opened longer will have a more positive impact than new accounts.
  • 10% of your score reflects new accounts that have been opened.
  • 10% reflects the different types of credit that you have.

How Credit Cards Fit Into Your Credit Score

Credit cards are important in building credit in all the areas that are used to calculate your credit score. Good use of credit cards will build positive credit, and irresponsible use will create a negative history with a low credit score.

credit cards build creditFirstly, credit cards can start your credit history by factoring into the 10% of your score that is calculated for new accounts. A new credit card account shows that the credit card company trusts your ability to repay and increases the overall amount of credit that has been extended to you. For instance, a new credit card account with a $1,000 limit will increase your extended credit by $1,000. A second credit card with the same limit will increase your extended credit to $2,000.

Next, credit cards affect the largest category, payment history, which determines your score. Credit cards are a form of revolving credit, and on time payments will start to create a good payment history; late or missed payments will have a negative impact. Similarly, once you have had a credit card for a while, that account will also begin to affect the 15% of your score that is determined by the length of your credit history. In addition, that revolving credit will improve the 10% of your score that is determined by different types of credit, when added to installment credit accounts such as auto loans and a mortgage.

Credit cards directly affect the other big chunk of your credit score, the 30% that shows how much you owe. This is where many people make a mistake, because they only make minimum monthly payments while the amounts they owe on their cards continues to inch towards their limits; they have used most of their extended credit.

The Federal Trade Commission maintains that a credit card account that has debt near the credit limit will negatively affect your credit score. Keeping your credit utilization under 30%, or only using 30% of your credit limit, will help to build good credit.

Using Credit Cards Responsibly to Build Credit

Remember, credit cards will only build good credit if they are used responsibly. They should only be used for emergencies or to buy costly items that you plan to pay off over time. If you only make the minimum payments on your credit cards, then your debt will continue to grow through interest and new charges. The most desirable action for a good credit score and financial freedom is to pay off your credit card debt in full every month.

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