Credit cards are powerful tools that can help you build excellent credit—but they can also sink your finances. Money Girl answers a listener question about healthy ways to use credit cards. You'll learn how the credit system works, tips to manage cards, and how credit affects your entire financial life.
How to Use Credit Cards to Build Credit
Credit cards are powerful tools to build credit when used responsibly. If you don’t pay them on time or rack up high balances, they will crush your credit.
Credit scoring models analyze the total amount of debt you owe on all your accounts. Additionally, for your revolving accounts, your available credit is a major factor that makes up about a third of your credit scores.
Revolving accounts are the ones that stay open indefinitely, such as credit cards and lines of credit. They don’t have a set maturity or pay off date and give you a set credit line to spend. As long as you make monthly minimum payments on time, you can continue to use revolving accounts forever.
Installment loans, such as car loans and mortgages, are different because they don’t have a credit limit and do come with a set maturity or pay off date. When you pay down an installment loan to zero, the account is closed.
A key formula that’s used to calculate your credit scores is called your credit utilization ratio.
A key formula that’s used to calculate your credit scores is called your credit utilization ratio. It’s used only on revolving accounts. It’s a simple formula that compares your credit limits to your outstanding balances. This ratio shows how much available credit you’re using.
For example, if you have a credit card with a balance of $1,000 and a credit limit of $2,000, your utilization ratio is 50% ($1,000 / $2,000 = 0.50).
Keeping a low utilization, such as below 20%, is optimal for good credit. So, by paying down your balance on the card to $400, you could reduce your utilization ratio from 50% to 20% ($400 / $2,000 = 0.20) and boost your credit scores.
A low utilization ratio tells potential lenders and merchants that you’re using credit responsibly. A high ratio says you’re maxed out and may even be getting close to missing a payment. To maintain the best credit possible, never let your utilization ratio exceed 20% to 25%.
Using credit cards responsibly is critical because your credit utilization typically makes up about 30% of your credit scores. This is second only to paying your accounts on time, which may account for approximately 35% of your scores.
When Is Credit Utilization Calculated?
A common misunderstanding about credit utilization is that it doesn’t matter how much you charge, as long as you pay off your entire balance by the statement due date each month. While I’m a huge advocate of paying off your credit card in full every month so you stay out of debt and avoid all interest charges on a credit card, it can still hurt your credit.
Here’s why: Credit cards report your payment information and account balance to the credit agencies on a given day each month. This date is typically not the same as your statement due date. It doesn’t matter whether you pay the balance off in full by the due date—the balance you owe on the reporting day is what shows up on your credit report.
So, even if you always pay off your balance in full, you can still have an outstanding balance on your report, and a high utilization ratio! They key is to keep your balances below 20% to 25% of each card’s limit, even if you plan to pay it off right away. Otherwise, a larger-than-expected balance will appear on your credit report.
If you use credit cards responsibly but still charge more than 20% of your available limit, one solution is to apply for a credit limit increase using your online account or by calling the card company. For instance, if your credit card limit was raised from $2,000 to $4,000 and you still owe $1,000, that drops your utilization substantially from 50% down to 25%, which is much better for your credit scores.
Another strategy to increase your credit scores is to use multiple cards so you spread out usage, so you never go over 20% of your credit limits. It’s much better to have two credit cards that each have balances below 20% of your credit limits than to have one card with a 40% utilization ratio.
Getting additional credit and spreading out your card balances can improve your credit scores quickly. Also, note that credit scores factor in both your ratio on individual revolving accounts and on the total of all your revolving accounts.
To learn more about taking control of your credit and pursuing your financial dreams, check out my online class, Build Better Credit—The Ultimate Credit Score Repair Guide. It teaches all aspects of building credit from scratch, how to prepare for a major purchase, and dealing with creditors wisely.