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Today, TPG contributor Jason Steele reviews how new credit card applications impact your FICO score, and reminds us to consider the big financial picture when playing the points and miles game.
There’s no way around the fact that credit card sign-up bonuses are among the quickest and easiest ways to earn points and miles. Even if you received your airline tickets for free, it would still take you around 100 hours in the air to earn 50,000 miles, which is what many credit cards offer after spending 60 seconds completing an application, and then using the card to make everyday purchases.
Yet I find that new points and miles enthusiasts are often reluctant to dive headlong into a card application out of concern for how it might affect their credit. So today I want to answer one of the most common questions I get from folks who are new to the game: “How do new card applications affect my credit score?”
Short answer: Not much
Opening a new line of credit has both positive and negative affects on your score. On the positive side, being extended a new line of credit reduces your debt-to-credit ratio (for a given amount of debt). Remember, your credit history and your credit score consider your “debt” to be the sum of all of your most recent statement balances, regardless of whether you avoid interest by paying them in full. Therefore, having a larger total line of credit minimizes your debt-to-credit ratio and improves your credit score.
As an example, suppose you had one card with a credit line of $5,000, and you maintained a balance of $1,000. Your debt-to-credit ratio would be 20%. If you then opened a second card also with a line of $5,000, your debt would remain the same, but your total line would be $10,000, so your debt-to-credit ratio would fall to 10%. This makes you appear less risky in the eyes of credit bureaus, and increases your score accordingly.
Opening a new card also increases your total credit history (the number of data points available for creditors to gauge your credit-worthiness). In fact, people who try to improve their credit score by avoiding credit cards, or having just one open account, often find that their scores are not nearly as high as they expected.
On the downside, opening a new line of credit can reduce the average length of the accounts in your credit history. It also impacts the portion of your credit score called “new credit,” which penalizes you for opening up too many new lines of credit in a short period. FICO doesn’t do this to discourage people from earning travel rewards, it’s just that their credit scoring formula interprets such behavior as a sign of financial distress, like someone taking out several new loans to pay bills.
On the whole, the positive and negative consequences of opening a new credit account largely cancel each other out. Those who open up a single new credit card account typically find that their scores go up slightly, as the scoring formula doesn’t really penalize them for adding a single new line of credit. Those who open up multiple accounts in a short period of time typically see a modest, temporary drop in their credit scores (although most see overall improvement as time passes and the average length of credit history increases).
This short-term drop is rarely significant enough to move an “excellent” credit score down to just “good,” but those who are about to apply for a new mortgage or other substantial loan would be wise to take a break from new credit applications until they complete the process. Besides, a mortgage application looks beyond your mere credit score and delves into the details of your credit report; applying for many credit cards will raise unneeded questions during that process.
I could go on all day about the nuances of debt-to-credit ratios and various theories on how to improve the average length of your credit accounts, but I don’t believe there’s much to be gained by diving too deep into that area. The exact FICO consumer credit scoring formula is a secret, but they disclose that your length of credit history only comprises 15% of your score, and the “new credit” portion is a mere 10%.
In contrast, your payment history makes up a whopping 35% of your credit score, and your amounts owed is another 30%, each of which is greater than the cumulative weight of your length of credit history and your “new credit.” The moral of the story, then, is to always pay your bills on-time and carry very little debt. If you do those two things, your credit score will likely be excellent (unless you go out of your way to avoid having any credit history at all).
The pitfalls of credit card use
There’s one crucial way that credit cards can upset your finances in general: interest. About two-thirds of American credit card users regularly carry a balance on at least one of their accounts, leading to costly interest charges. Many of these credit card users view opening a new line of credit as an invitation to spend more money and incur more debt.
Those who carry a balance that accrues interest on their credit cards should forget about earning travel rewards and instead focus on paying that debt off as soon as possible. Reward credit cards invariably have higher interest rates than non-reward cards, and offer less attractive promotional financing. Earning $25/month in airline miles won’t do you any good if you’re losing $25/month (or more) to interest by carrying a balance.
Furthermore, those who would be tempted to use a new line of credit to make unnecessary purchases, or who have trouble controlling spending, should question their use of credit cards altogether.
Credit scores and credit cards are tools, and like many tools, you should learn to wield them correctly or someone will poke an eye out. Credit card applications won’t hurt your credit score in the long run, but make sure your applications and expenditures are sensible in the scope of your own personal finances. Spend responsibly, and pay your balances in full and on time, and both your credit score and your points and miles accounts will prosper.
For more information about credit card applications and FICO scores, check out these posts: