Using Credit Cards Wisely
Using your credit cards wisely is the best way to build your credit scores. The thing is, “what does that mean?”
What is a Credit Card
The history of credit cards is still fairly recent. The first ones came out back in 1950 and were produced by Diner’s Club. American Express came out just a few later in 1958.
The credit card is a type of credit known as “revolving loan”. There are only two types of credit out there. One is revolving credit and the other is the installment loan.
The latter is a one-time borrowing of funds which is paid back over time and has some type of collateral attached to it. Car loans use the vehicle as collateral. Home loans are another type of installment loan where the home is the collateral.
Other types of installment loans are loans from companies like Dell Computers when you buy a one time purchase and you pay it off over time. This can be done with large appliances and furniture. Installment loans are a great way to build your credit as they are paid off over time and once paid off will show up as a paid off.
The only installment loan I can think of that doesn’t have collateral attached to it are school loans. This is not the topic of this blog to talk about installment loans and their use. But, you should use them often when making purchases and make sure you pay them off on time.
The other type of credit is one that can change up or down on a monthly or regular basis. This is most notably seen in credit cards (e.g., Visa, MasterCard, American Express) and store cards (Victoria’s Secret, Wal-Mart).
Revolving credit is a great and convenient method to exist in today’s almost cashless society.
This can be as hurtful as they are helpful. If used unwisely then people can overspend and get into debt beyond their own control.
If your balances are too high this can be a reason you may not be able to qualify for a home loan.
There are a few words you need to know before we touch on how to use credit to your advantage.
The first is Debt to Income Ratio (or DTI Ratio).
When attempting to get any new line of credit one of the key factors on if you qualify and how much you qualify for is going to be based on how much debt do you have monthly compared to the income you have coming in.
Obviously, the higher the DTI the lower the chances of getting new lines of credit.
Another word you will need to know is Credit Utilization. This term means how much of your credit balance are you currently carrying. The higher your credit utilization the fewer chances of obtaining a loan.
Here is how it works. Assume you have a $10,000 credit limit either on one card or across all of your revolving credit amounts. If you are carrying $5,000 on average your credit utilization is $5,000/$10,000 or 50%. If you are carrying $1,000 then you would be at 10%.
Most lenders agree that good credit utilization should be at 30% or less.
Using Credit Cards to Your Advantage
I have spoken with a number of people over the years about how to use credit cards to build their credit profile.
This can help anyone and is also perfect for people attempting to establish credit for the first time. The first timers are often people who have just become Americans or a teenager just turning 18 (or even younger if the parent signs the documents on their behalf).
Here is what you do. I am going to assume you have no credit cards at the moment. You can do the same if you paid off all of your balances or you have at least paid them down to less than a 30% credit utilization.
Many people are under the FALSE belief that they need to pay off their credit cards every month. They were told by their parents or grandparents that carrying a balance is bad. I will be the first person to say to you that paying them off every month is a horrible thing to do.
Here is why. You cannot think of this like a human doing this. You have to think like non-emotional logical thinking … machine.
Let me set up the machine world thinking so you can fully understand the process.
Let say I am applying for a loan with Bank You. You will want to see my credit report. I am a good guy and give you a copy of it. You see I have three credit cards. Then you see that every month when the credit company reports to the big three repositories (Experian, Equifax, and TransUnion) that my overall credit limit is $10,000. Lastly, you see my monthly balance on the cards is $0 every month.
I tell you that I use them all of the time. I want to get my frequent flier miles. But the computers say I don’t use them because the credit card company only reports once a month (which is typically after the late payment date).
What are the chances you are going to give me a loan? Let’s assume you are a computer when I am applying online. They see no activity so they are going to be less likely give me the loan.
On the other hand, my twin brother comes in and you see that in January I had a $400 balance. February I had a $200 balance. In March it jumped up to $1000. In April $850.
Bank You sees “activity” on the account. Balances are going up and down. They show I am using the account. And, most importantly I am keeping it below the 30% credit utilization threshold.
When I was a college math teacher I often had students just out of high school. I would tell them to use a new credit card for all of their gasoline purchases. With each purchase put it on the credit card but to also put the cash equivalence into an envelope (or separate bank account) and when that statement came in to pay “most of” it off. Not all of it. Bang! Activity and still having the full cash amount available.
Where to Find Credit Cards
There are a number of sites you can apply to get new credit cards.
I am going to take a side note on the second link above. If you go to Credit Karma they will give you a credit score. Ignore that score. It is highly inaccurate. But, it is a great source of giving you an estimated credit score and what cards are best for their interpretation of scores. Thus, if you are just starting out and they say Low or Non-Existent then they will steer you towards the cards which best fit that score. Read more on Credit Karma by reading my blog on them.
Getting credit and using it wisely is the best way to getting good credit scores. That is going to help you in your future life and being able to qualify for homes, cars, and possibly even upper-level jobs.