Addressing the Fears of Leveraging Credit Card Rewards Part 1: The Dreaded Credit Score

This is part 1 of a series of posts about fears or roadblocks that prevent people from taking advantage of credit card rewards. My hope is that this series will help people take the first step toward the rewards they deserve!

If you are interested in free travel, credit cards rewards are the name of the game.  Is credit card use for everyone?  No.  If you cannot pay your bills on time from month-to-month, or if you don’t have the discipline to only spend what you have – credit cards can be your financial downfall.  However, if you have a budget, only spend what you have, and are disciplined enough to make on-time monthly payments – you can benefit greatly from credit card use.  

However, whenever I have a 1-on-1 consultation (especially among those who could most greatly benefit and have the discipline), one of the questions most often asked is:

"How will applying for credit cards affect my credit?" The short answer is that it may initially cause a small dip in your credit score, but over the long run, it will actually boost it!

For some of you, this may not have been the answer you thought you’d get. But it’s true! If you’re skeptical or curious how this can be, I’m going to break-it-down in this post, and hopefully, after reading it, you will be less worried about your credit score and more excited about when you’ll be able to take your next trip!

So here’s what I’m going to hit on in this post:

  • What is credit and why is it such a big deal?
  • How is my credit score calculated?
  • How can applying for and having more credit cards, to maximize rewards, actually help my credit score?

 

WHAT IS CREDIT AND WHY IS IT SUCH A BIG DEAL?

Credit is defined as: The ability of a customer to obtain goods or services before payment, based on the trust that payment will be made in the future.

So if we are to break this down, your credit score is simply seen as your ability to pay back the credit that was extended to you, to purchase the stuff you want.  If you have a “good” credit score, lenders look more favorably on extending that credit to you (whether it be a car loan, credit card spending limit, or home mortgage) because in their eyes, a higher score equates to higher credit trust worthiness – that you will have the ability to repay.  If you have a “poor” credit score, lenders will be hesitant to lend to you, as your credit history has shown that you’ve had poor credit trust worthiness, and perhaps poor ability to repay that loan.  This leads us to the next question.

 

HOW IS MY CREDIT SCORE CALCULATED?

There are several different credit score providers, but the most popular and well known provider is FICO.  A FICO score is calculated by various categories of data from a person’s credit report, and how much each category contributes to your FICO credit score is in the chart below:

 

HOW CAN APPLYING FOR AND HAVING MORE CREDIT CARDS, TO MAXIMIZE REWARDS, AFFECT MY CREDIT SCORE?

Based on the criteria for calculating a credit score outlined above, the one’s listed below are the top three areas that can immediately and easily affect your credit score (good or bad). After I describe the top three, I’ve included an example of how two of them can work together to help or hurt your credit score:  

Payment History: As you can see from the pie chart above, the biggest piece of your credit data that affects your score is ‘payment history’, at 35%.  Which means, if you make your payments on time, you will fare well in this category, while if you don’t pay on time...

Amounts Owed: The second category at the top of the list is the ‘amounts owed’ category, at 30%.  This compares how much you owe vs.  your total available credit limit (across credit cards for example). This is also called your debt-to-credit ratio or utilization.

New Credit: The last important category that can affect your credit score is the ‘new credit’ category.  Each time you apply for and open a new credit card, there is a hard inquiry on your report.  A hard inquiry is simply a notation for creditors to see that you’ve applied for some sort of new line of credit.  Although a few inquiries are not a cause for concern, multiple inquiries can cause your credit score to dip temporarily.  But, what is important is your overall credit profile and what is already included on your credit report.  Yes, if you have very little credit history, plus poor on-time payments, a new inquiry will affect your score negatively much more than say, 20 years of on time payments.  Makes sense, right?

Keep in mind, that though there may be small drops in your score with each new application, ‘new credit’ only makes up 10% of your total credit score.  New credit applications are actually beneficial in the long run, as additional lines of credit actually help create better debt-to-credit ratios, which is part of the bigger 30% ‘amounts owed’ category that make up your total score. There is probably only one time when you do not want to apply for new credit cards and that is if you are getting ready to buy a home. If you are buying a home in the immediate future, you’ll want to wait until after you complete the transaction.

Here’s an example of how Amounts Owed and New Credit work together to affect your credit score:

  • Owed across credit cards: $3,000
  • Total credit line: $10,000
  • Utilization: $3,000/$10,000 = 30%

I apply for and get approved for a new card that gives me an additional credit line of $20,000.

  • Owed across credit cards: $3,000
  • Total credit line: Previous $10,000 + New $20,000 = $30,000
  • Utilization: $3,000/$30,000 = 1%

In the example above, by applying and getting approved for a new card, I have lowered the ratio used to define the amount owed. Basically, having more available credit, but keeping your spending the same, is good for your credit score. Where people often get into trouble is they start spending more when they get more credit, which isn’t so good (especially if you can’t pay it back on time).

Unfortunately, there is no “publicly available” equation as to how Experian, Equifax, and TransUnion come up with the actual scores from person to person, but these percentages give a general picture/guideline as to how a person’s credit score is calculated.  

Ok, are you still with me? If the answer is yes,  we have now hit on all the pertinent information to understand the answer to our initial question:

"How will applying for credit cards affect my credit?" As I said at the beginning, opening new cards may initially cause a small dip in your credit score, but over the long run, it will actually boost it!

 

Ok, so if this post has made you want to learn how to leverage credit cards for rewards, click HERE, or you still have some hesitation about doing so, click HERE to subscribe for future posts on this subject.