Everyone is talking about credit score nowadays. Some are still trying to understand the concept of credit score and others, who have it all figured out, are working on improving their own scores. There are a lot of factors that affect your credit score, credit cards being the most common. Some people get credit cards for the sole purpose of building credit so that they can get better rates on loans in future.
Credit scores are assigned by credit bureaus like TransUnion CIBIL and Experian based on the information furnished by the lenders. It is a record of your loans accounts and credit cards and helps other lenders in judging your ability to repay the loan you seek. Your credit card issuer also shares important information related to your overdue balance, available credit limit, payment history, etc. and all of these, along with the details of other loans you have taken, make up your credit score.
So, let’s have a closer look at how credit cards, in particular, affect your credit score.
Having a Credit Card
Just having a credit card is enough to start you on the credit journey. Those who do not have any open credit cards or active loan accounts will not have a credit score. Not having a credit score may come as an obstacle when you wish to take bigger credits like home loan, car loan or even personal loan. Since credit score is a mirror of credit behaviour, the bank would not be able to judge whether people without credit score could make regular repayments or not. There are several other factors that come into play but the credit score is the first thing that the lenders look at. Even if you get approved for a loan without a credit history, you may not be able to negotiate a better rate of interest.
A credit card is one of the easiest ways to start building credit. Some banks would be ready to give a basic credit card to those with no credit history. For example, HDFC MoneyBack Credit Card and ICICI Platinum Chip Card are popular among people who are new to credit. After getting the card, you should use it wisely and it will have a positive impact on your score.
Your Available Credit Limit
Your credit limit is the maximum amount that the bank has made available to you after judging your financial capacity. At any given point, you cannot spend above this limit and if you do, you will have to pay hefty charges. As you make purchases on your card, this limit gets decreased by the amount of your purchase and as you make payments, the available limit increases. It is not a good practice to max out your credit cards as it will increase your credit utilization ratio. A high utilization ratio translates to bad credit score.
Credit utilization is the ratio of your outstanding balances to the total available limit. It measures how much of your credit limit you are using. Lower the ratio the better it is for your profile. You should not bring your utilization limit above 30 percent. People with high utilization are considered risky borrowers and hence you will face problems in getting loans or more credit cards. Maintaining a lower ratio will show the banks that you can manage credit responsibly.
Related Read: Tips for Lowering Your Credit Utilization Ratio
Your Overdue Balances
The balances you carry on your credit cards make up a major portion of your credit score. But how it affects your score is a tricky thing. If you keep paying the minimum amount due every month and rolling the balance over to the next month, it is not considered as late payment. So, your credit score will not be affected in this case. However, when you roll over credit, you are adding to your own financial burden in the coming months which may be difficult to pay off at once. It will increase your credit utilization ratio and dip your score. In a different scenario, say you are not able to pay even the minimum amount due on time. Late payment will be reported to the credit bureaus and your credit report will show the number of days after the due date for which your balances lay unpaid in the DPD (Days Past Due) section. This is why you should always pay your credit card balances in full and on time.
Number of Credit Cards
This is again a tricky part of your credit score as the bureaus have not defined the number of credit cards one should have. You can have as many credit cards as you can get approved for. Walter Cavanagh from California USA took this statement seriously and made the world record of having 1,497 credit cards and was conferred the title of Mr. Plastic Fantastic. The funny thing is he also had a fair credit score at the time and was denied only once.
What we are trying to say here is that there is no limit on the number of credit cards that you can own. It is up to you whether you can manage more cards. Since, people in India have not developed the love for plastic money yet, most of us usually have only 2-3 credit cards. In such a situation, someone having 6-7 credit cards may be considered as a credit hungry borrower. Relying solely on one credit card is also not good so you should have a basic card and another one that is more aligned to your favorite spending categories.
Read More: How Many Credit Cards Should You Have?
How opening and closing credit card accounts affect your credit score?
Having a credit card is important to build your credit score and improve it with responsible usage. If you do not have a credit card but other types of loans, it will still help to get a card. This is because most other types of loans are installment debt and credit cards and line of credit are considered as revolving debt. When you have a mix of revolving debt and installment debt in your profile, the bureaus find it to be good and hence your score improves.
People who already have a credit history with other types of loans are wary of credit cards. This is because of the stigma around credit cards. They find credit cards to be something that induces debt spiral and trashes credit score. Let us clear this cloud of confusion and learn about how opening and closing a credit card impact your credit score.
- Opening a Credit Card Account
This is basically getting a new credit card. When you apply for a new card, a hard enquiry is initiated on your credit profile which will lead to a slight drop in your score. This drop is only temporary; after a few regular payments, your score will recover. But if you apply for too many credit cards and loans at the same time, the collective effect may be vicious for your credit score. This can also work the other way round. In case you have a high credit utilization ratio, you can get a new credit card. Your credit score would suffer a slight drop initially but the extra credit limit on this new card will reduce your overall credit utilization ratio thus improving your score in the long run. A new credit card account takes about three months to show up on your credit report so you should be patient.
- Closing a Credit Card Account
Opening a credit account leads to a slight drop which later picks up and improves your score. On the other hand, when you close a credit card account, your scores may take a big hit. This is because credit history makes up for a better part of your score. So, if you close an account that has been there since the beginning, you are erasing years off of your credit life. Secondly, your credit utilization ratio will also drop as you no longer have access to the credit limit of the card you just closed.
Credit Cards and Credit Score: Myths vs. Facts
Since there is stigma around debt in India, several myths have been floating around which may discourage you from getting a credit card. It is important to know the truth about these so that you can make a wise decision.
Myth #1– Credit cards cause debt spiral and lead to low score
Though a lot of people in India are using credit cards for quite some time, they do not have clear idea about how it works. Those who manage to pay back the entire outstanding amount each month are safe from debt while others who keep balances overdue get stuck under a pile of debt and their credit score goes downhill. This happens only when you make reckless use of your credit card and revolve overdue balances every month. When you take balances to the next cycle, you have to pay hefty interest on the amount. Also, the new purchases you make would not be eligible for the interest-free period, adding to your financial misery. So, the rule is to pay your credit card balances in full and on time.
Myth #2- You should have only one credit card
This myth is also connected with the previous statement that credit cards cause debt. People think the more credit cards they have, the more debt they will incur. However, there is no rule as to the number of credit cards one should have. It is just that you should be able to manage the bills on each of the cards you have. Unless you miss a payment, your credit score will not be affected.
Myth #3- Credit limit increase is a scam
Many times, banks will contact you to offer a higher credit limit on your card. People think this is a scam but honestly there is no catch in it. If the lenders find you to be a responsible borrower, they can offer you a higher credit limit as they think you can manage your finances well. You should not decline such offers as a higher limit will reduce your credit utilization ratio which works out really well for your credit score.
The Bottom Line
Your credit score is directly related to your credit cards and other loans you have. If you are already serving a loan but do not have a credit card, getting one will be good for your scores. A mix of credit is considered a good practice by the bureaus. Also, with credit cards you can make big purchases and pay for them in easy EMIs. To build and maintain a good credit score, you should serve your loan EMIs regularly. Pay the total amount due on your credit card every month. Stay below a utilization limit of 30 percent. Adopting good credit habits will lead to an excellent credit score.