How a credit card affects your credit score

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A credit card gives you an option to borrow money up to a given limit. This form of debt is unsecured, transactional and revolving. This makes a credit card debt more costly in terms of the interest rate charges. So how does a credit card affects your credit score?

Key takeaways

From this article, we will focus on the following:

• Age and Payment history of a credit card
• Credit utilization

Defining credit card debt and credit score

For us to be able to clearly understand how a credit card affects your credit score, we need to start by understanding both the credit score meaning and how the credit card works.

Credit Card

Let us define the three components of credit cards stated earlier.

Component	Explanation
Unsecured	Credit cards are not attached to any assets of the borrower. That is if the borrower defaults, a lender will not sell a borrower’s asset to pay for the debt.
Transactional	Just like debit cards, credit cards can be used for day to day purchases.
Revolving	Credit cards gives you an opportunity to withdraw again part or all of the remaining balance before you repay the outstanding balance.

The transactional and revolving nature of credit cards make it difficult to pay off credit card debt completely. Additionally, since credit cards are unsecured, it poses a greater risk to the lender since all the outstanding balance can be lost when the borrower defaults. To cover for this, the creditor will issue credit cards at higher interest rates.

Note: There is another type of credit card that is secured. With this Secured Credit card, a cardholder is obliged to pay a security deposit that acts as a collateral.

Credit Score

Credit scores are used by lenders to assess if the person who is applying for debt deserves it or not. A high score makes a lender more confident that a borrower will pay off the debt in the future.

It is worth pointing out that this score heavily depends on your previous behavior with debt. Therefore if you haven’t borrowed any money in the past, you will not have any credit score. This credit score has nothing to do with the size of your savings or investments.

The following are some of the factors that affect your credit score:

• Payment history of your debts.
• The age of your debts.
• Credit utilization
• Number of credit inquires
• Court judgments and defaults

How does having a credit card affects your credit score?

Now you have an understanding of what a credit card and credit score are, the next step is to understand how a credit card affects your credit score.

The Age and Payment History of your credit card

To many people a credit card is the first form of credit that you can qualify for. The older your credit card is, the more it affects your credit score.

The advantage of a credit card is that, you can have it to build a credit score without having to be in debt. Having a credit card gives you an option to borrow but you are not obliged to borrow the money.

Most people use credit cards to get shopping rewards then immediately pay it off so that there will not be any outstanding balance on it. This makes a credit card a very useful tool for someone who hates debt but wants to build a good credit score.

As long as you are paying your credit card debt as soon as you use it, you are building a good credit score for yourself. However, if you use your credit card and forget to pay the minimum payment required, this will tarnish your payment record.

Credit utilization of your credit card

Credit utilization is one of the most important factors of a credit score. It measures how you are likely to use the debt available to you.

A lower credit utilization shows a great discipline towards debt. This discipline is what gives a lender more confidence that you are able to pay back what you borrow.

To illustrate this, we assume that you have a credit card with a limit of R 50 000. If you spend R 10 000 from your card then your credit utilization will be calculated as follows:

As a rule of thump, aim to have a credit utilization of less than 0.3 (that is 30%). Your credit utilization will start to have a negative impact on your credit score if it exceeds 0.5 (that is 50%).

Summary

A credit card can be very useful if you are aiming to build your credit score. However, it’s usefulness heavily depends on your discipline.

A credit card can be used to start building a credit history even without you having any debt which is more attractive for people who hate debt. The credit utilization of a credit card contributes more towards your credit score.

A credit card affects your credit score heavily. Therefore, you need to use it wisely otherwise it will do more damage than good.

Useful articles about managing debt:

• Bad money habits can lead to depression
• Getting out of debt