How Credit Cards Affect Your Credit Score
Credit cards can affect your credit score in both positive and negative ways. What follows are a few of the ways they can impact your credit score.
Officially closing a credit card account will lower your credit score because it (1) might reduce the length of your credit history, which accounts for 15% of your credit score, and it (2) lowers the total amount of credit you have available, which will raise your debt to available credit ratio.
To illustrate this, assume that one person has two credit cards each with a $5,000 credit limit. This person habitually carries a $2,500 balance on one credit card. With two credit cards, this person's debt to available credit ratio is $10,000/$2,500 [total credit available/total debt]. This means that this person only uses 25% of his overall available credit, which is good. If he closes one credit card, his ratio is now $5,000/$2,500, which will lower his overall credit score since he is now using 50% of his available credit.
Does this mean that one could open new credit card accounts just to improve his debt to available credit ratio? Yes, one can, if he or she doesn't already have too many open credit card accounts. Too many credit card accounts can also lower one's credit score.
On the other hand, having an open credit card that you never use can also negatively affect your credit score since, if you don't use it occasionally, the credit card issuer might stop reporting your activity altogether. Therefore, use your credit cards occasionally in order to help your credit score.
There is another way that credit card use can negatively affect your credit score, even if you pay off your credit card balances every month. Suppose that you use your credit card to purchase gas, groceries, and everything else each month, always spending around $1,500 each month, but when the bill arrives, you pay the balance in full. One would think you would get bonus points for staying out of debt and paying off the balance in full each month, but not when you consider how you look on paper.
Your credit card issuer is reporting to your credit report each month the total amount you owe at the time of the report and that you pay on time, not the fact that you pay your balance in full each month. Therefore, on paper, it looks like you carry a $1,500 balance on your credit card and never pay it off. Therefore, a good idea would be to have 2 or 3 credit cards and rotate them, using one for a few months, then using another, so that your credit card company can report a zero balance every few months to the three credit reporting agencies.
Credit Cards and Credit Scores
Note that in the months immediately preceding applying for any type of loan, particularly a mortgage loan, it would be a good idea if you paid off your credit cards in full and didn't use them for awhile, giving your credit card issuer at least one month to report a zero balance to the credit reporting agencies. The amount of debt being reported on your credit report is a very large factor in determining your credit score and the interest rate you will be granted, which could result in paying tens of thousands of dollars in additional finance charges on a mortgage loan.