We all use that little plastic card to make purchases, but have you ever taken the time to learn how do credit cards work? Credit is paying for purchases with borrowed money. In exchange for financing you pay the lender back the money you borrowed plus interest. Credit can be used to purchase houses, credit card purchases and loans. So you have to wonder how do credit cards actually work? And how do I become creditworthy to credit card issuers?
First things first, you’ll need to take a look at your credit history by looking at your credit report. The three main credit bureaus, TransUnion, Experian and Equifax create your credit report using models like FICO to come up with a score that typically ranges from 300-850.
Fair Isaac, the makers of the FICO score, is tight-lipped about exactly how the scores are calculated. But they do give weights on the criteria they look at. 35% payment history, 30% amount owed, 15% length of history, 10% new credit, 10% types of credit used. Your credit score is only calculated based on the information in your credit report. It does not reflect personal information like how long you have been employed. So it’s really important that you have good marks on your report for high scoring.
Breakdown of Criteria
Payment history is the largest portion scored on your report so making on time payments and payments above the minimum amount due is imperative for your creditworthiness. Your amounts owed reflects on how much total credit you have available and how much total credit you are accessing. This makes up your credit utilization ratio. Experts say to keep it below 30%, for excellent credit keep it to 20%. So if you have $1,000 in total available credit to you do not use more than $200-$300 of your credit limit.
Length of history refers to how long your accounts have been in good standing. Keeping your accounts open and active will help the scoring process. The longer you have an account the better off you are. If you have been making on time payments for 10 years versus 6 months you are very creditworthy. New credit refers to new accounts, opening new accounts is good for your credit. It increases your total credit available to you. But there is a way to do it that is healthy and not harmful. And lastly looking at the types of credit you have, credit cards, store cards, student loans, auto loans, personal loans, mortgages, insurances.
If you are just starting out, it may be difficult to get approved for a credit card. No credit can sometimes be viewed as worse than poor credit. But there are ways that you can prove your creditworthiness to lenders in addition to offers specially designed for people just starting out with credit.
How to Build Credit with Credit Cards
If you are a student, you may be eligible for a student credit card. You must be enrolled into a college or university and have no prior credit history. This type of offer is only available for first time cardholders and is an opportunity to start building your credit with an unsecured credit card. Your starting credit limit will be low as you are still viewed as a risk, but the approval process is easier than any other type of card for first time applicants with no credit history.
Another option is a limited purpose credit card which is more commonly known as a store credit card. Just like any other credit card there are still finance charges and minimum payments due, so you still have to act responsibly with them. This is a great option to start building credit and you may have an easier time getting approved for a store card rather than a major credit card because it’s less of a liability.
If you’re still having trouble getting approved for a credit card, you can open a secured credit card. This type of card builds your credit. The way it works is you leave a secured deposit and the amount of your deposit is used as collateral for a credit limit. There are still monthly minimum payments due and interest rates like an unsecured credit card. You absolutely need to pay on time because your payments are being reported to all three of the major credit bureaus to build up your credit.
Always, always make your payments on time! Credit Card companies generally have a 21-day grace period between the purchase date and when the payment is due. Payments are the largest weighted factor that determine your FICO score. This category accounts for 35% of your score, so even one missed payment can set you back. With today’s technology there are so many ways to avoid missing your payment or late payments.
Tips for Making On-Time Payments
Set up reminders with your credit card issuer. Your issuer will send you a notification when your statement is ready and a few days before your payment is due prompting you to pay. Need even less to stress about? Set up auto pay. Determine a set amount or to pay your balance in full ahead of time and let the magic happen without you having to worry. There are even apps on your phone, like Mint that will track your credit cards and let you know when your payments are due and suggest a payment amount to make.
If you do all of your banking on a certain date, contact your issuer and request your payment due date for a certain day of the month so everything is synchronized for you. They want you to pay your bill and succeed with them.
And in the event you miss one payment, see if your issuer has late payment forgiveness and will pardon the late payment. If it never happens again you should have nothing to worry about. But if it turns into a pattern it will be reported to the credit bureaus and affect your credit score and your credit limit may be decreased or the account could even be closed. So it’s best practice to stay on top of your payments.
With all of the artificial intelligence out there reminding us and taking the leg work out of the equation there really is no excuse to miss a payment.
Balances and Finance Charges
Think of your credit card like a debit card, and don’t swipe it if you don’t have the funds available to immediately pay it off. It is always best to pay your bill in full each month. It is a myth that you need to carry a small balance on your credit cards to help your credit. If you can’t swing it, pay as much as possible and commit to paying it down to zero the following month.
The balance you leave on your credit card will be subject to interest charges. For credit cards, interest is expressed as a yearly rate known as the annual percentage rate, or APR. Though APR is expressed as an annual rate, credit card companies use it to calculate the interest charged during your monthly statement period.
Your APR will be determined by your credit score. The higher your credit score the lower your APR will be. So it is important to continuously work on building and improving your credit as it costs more money to have poor or even fair credit.
To calculate your monthly APR charges, follow the below equation:
- Divide your APR by the number of days in the year.
0.1799 / 365 = a 0.00049 daily periodic rate
- Multiply the daily periodic rate by your average daily balance.
0.00044 x $1,300 = $0.64
- Multiply this number by the number of days (30) in your billing cycle.
$0.66 x 30 = $19.20 interest charged for this billing cycle
Increasing Your Limit
Now that you’ve been making on time payments and paying more than the minimum payment due it’s time for a credit limit increase. Don’t go planning your shopping spree, this increase is for strategy not for spending. Your credit card issuer will review your account every six months. And give you a credit increase periodically if your account is in good standing.
If it hasn’t occurred naturally you will need to contact your issuer and request an increase. Note: don’t call and look desperate and give them a sob story, this will not get you the increase. Call and tell them why you deserve to get an increase in your credit limit. You’ve been a loyal customer for X amount of time (minimum 6 months), you pay your balance in full each month or more than the minimum payment, your payments are always on time, you just received a raise.
A credit limit increase is anywhere from 10-25% and can be substantially more based on your creditworthiness. Once you’ve been approved for a higher limit, and your total credit has increased, your credit utilization rate will decrease. The increase wasn’t for you to shop, it was to improve your creditworthiness by increasing the total credit available to you to decrease the total percentage of credit used.
Don’t go on a credit limit increasing spree. Only do one card at a time. Each time you increase your credit limit, the issuer needs to pull a hard inquiry on your credit report. Dropping your score a few points. One inquiry won’t do anything. Several inquiries will raise a red flag and hurt your credit score. So be patient. The more responsible you are with your credit cards, the more organic credit limit increases you will receive.
The Bottom Line
We all may be tempted at times to use our credit cards to splurge on something. Who hasn’t fallen victim to some retail therapy? But it’s important to know how credit cards work so you are continuously building up your credit. And when it comes time to purchase your dream home you get approved for a mortgage with the best rates. If you’ve racked up debt on your cards it’s okay, commit to a plan to pay it off and start creating healthy habits with your credit cards to build the best financial future you can for yourself.
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