Personal Finance: Managing a Credit Card

Getting a credit card can be an empowering experience. You no longer have to pay with cash, and you can build up your credit score. You might even get some cash back rewards with it. But be reckless with it, and you’ll be one of the 40% of US households with credit card debt. Managing a credit card is one of the most important skills in life because your credit score will determine whether or not you’ll be able to get a loan for major purchases later on, such as a new house.

How Does a Credit Card Work?

Credit cards are not gateways to free money. They are essentially short term loans. You spend the credit card company’s money when you use them, and after a month, the credit card company expects you to pay them back in full. If you don’t, they’ll start charging you interest on the remaining balance. Do this enough times, and you’ll rack up so much interest that you won’t be able to pay them back at all. That’s when people usually declare bankruptcy. So, it’s very important to make sure you pay in full and on time.

Credit Scores

If a friend likes to borrow money from you but never seems to pay you back, are you going to keep lending him or her money? That’s what a credit score determines. It’s a “grade” on how likely you are to pay back a lender. As you now know, credit cards are like “practice loans”. Paying your credit card bills on time and in full over and over again raises your credit score because it shows that you can keep track of your finances. When you need a real loan, lenders look at your credit score to see how likely it is that you’ll keep up with loan payments. If it’s too low, then you probably won’t get the loan.

The most widely used credit score is the FICO score. Actually, there are 28 FICO scores across all three credit bureaus (Experian, Equifax, and TransUnion), but they’re all just slightly different variants of the same thing, just used by different lenders. This score is split into 5 ranges: 800+ is exceptional, 740-799 is very good, 670-739 is good, 580-669 is fair, and < 580 is poor. Here’s what goes into calculating your score:

Payment History (35%): Paying your bills on time raises this score, while paying late or missing payments entirely hurts it. The severity and frequency of late payments as well as how recent they are all factored in. That means that you can improve your score after a late payment by paying your bills on time for a while.
Amounts Owed (30%): This is the total amount you owe, the number of accounts you have that have balances, and how much of your available credit you’re using. Using lots of your available credit will lower your score because it can mean that you’re overextended and at risk of not being able to pay your loans off (defaulting). Keep your balances low (generally below 50% of any single credit card’s credit limit and across all credit cards) for this reason. Also, avoid closing unused accounts (you’ll have a lower credit pool) or opening new accounts to have a higher credit pool (see the New Credit section below).
Length of Credit History (15%): Here, the score takes into account the age of your oldest and newest accounts (also the average age of all accounts) and the age of specific types of accounts. Longer credit histories generally improve your score.
New Credit (10%): This part is about how many new credit accounts you’ve opened (or applied for) recently and whether you’ve been rate-shopping for a single loan. Opening many accounts within a short time, especially if you don’t have a long credit history, will lower your score.
Credit Mix (10%): This part deals with what kinds of credit accounts you have (credit cards, retail accounts, installment loans, finance company accounts, or mortgage loans). It’s not necessary to have one of each of these to get a good score.

It’s important to note that if one or more parts is lacking data (for example, if the credit history is short) other categories will be given more weight.

Tips on Using Credit Cards

For the most part, there are no quick fixes to improving your credit score. It requires a long history of being financially responsible and managing your credit card(s) properly. Here are some tips that may help you reach that goal:

Zero that balance at the end of each statement period: Don’t just pay the minimum amount. Paying your bills in full and on time has the most positive effect on your credit score. If you really can’t, pay off the cards with the lowest balance or the ones with the highest interest rate first (make sure to pay at least the minimum on all cards). Then come up with a plan to pay off the other cards.
Don’t just ignore debt: From all you’ve learned, this should be obvious. Not only will your interest rate skyrocket, it will absolutely destroy your credit score. If you need help paying off your accounts, contact your credit card companies to see if you can renegotiate your payments or see a legitimate credit counselor.
Set up reminders: If you need help remembering when your bills are due, set up reminders for yourself. You can also usually get the credit card company to email you a set number of days before the due date as well.
Set up email notifications for your balances: Many credit card companies will give you an email alert when your balance exceeds an amount of your choosing. Use this feature to prevent yourself from overspending or to identify potentially fraudulent activity.
Don’t put huge payments on a credit card: For very expensive things like medical bills, see if you can set up a payment plan instead. Putting it on a credit card will just add a huge amount of interest to the amount you owe if you can’t pay it off immediately.
Don’t obsess over credit card rewards: Rewards like cash back are great if used properly. But don’t try to spend more just to get more rewards. You might overspend and end up not being able to pay off your bill. Not only will that mess up your credit score, depending on the rewards program, you might lose your rewards. Just treat rewards programs as minor discounts or bonuses for your purchases.
Pick cards that don’t have an annual fee: Seriously, a card that has an annual fee is just a ripoff. You have to pay to get rewards back? No, thanks. It’s a way to coerce you into spending more (in order to make the rewards worth it), and any card that does that is evil.
Pick the right rewards program for you: If you spend a lot on a particular category (like restaurants, supermarkets, department stores…), pick the card that gives the most cash back in that category. Don’t get too many cards, though, for the reason below.
Don’t have too many credit cards: Each additional card means another monthly statement to manage. Having too many cards increases the chances that you’ll miss a payment or overspend.
Try not to have just one credit card either: Remember, you want to try to stay below 50% of your total credit limit to avoid hurting your credit score. If you have just one credit card, it increases the chance that you end up going over 50%. Not only that, if an emergency hits, you might not be able to cover it if your one card’s credit limit is too low.

(Be sure to also check out my post about managing a budget: Personal Finance: Making a Budget)