I often chat with people about free travel and our experience with credit card rewards. Initially, some individuals are skeptical about it all, and many people are concerned that applying for credit cards will completely ruin their credit.
I’ll admit, when I first heard about credit card rewards, I had similar questions. The whole idea seemed too easy.
In this article I’ll present the facts and argue that new credit card applications can improve your overall credit health and credit score.
What is Your Credit Score?
Your credit score is supposed to represent your trustworthiness to banks and other institutions that lend money. It reflects the likelihood that someone will pay back borrowed debts on time. A higher score indicates more trustworthiness, and less risk for the lender. A lower score indicates potential problems with repayment, and therefore more risk for the lender.
The FICO score is the best-known and most widely used credit score model in the United States. The FICO model is used by the vast majority of banks and financial institutions, and is based on consumer credit files of the three national credit bureaus: Experian, Equifax, and TransUnion. Because a consumer’s credit file may contain different information at each of the bureaus, FICO scores can vary depending on which bureau provides the information to FICO to generate the score.
This is all to say, when you apply for credit of any type, the lender pulls your credit report and score from one (or more) of the three bureaus listed above. And although each can report slightly different scores, they tend to reflect the same information. If you default on a loan, it’s going to show up across all your credit bureaus. Likewise, if you continually pay your bills on time and limit your credit utilization, your FICO score will increase across the board.
What Determines Your FICO Score
FICO discloses the composition of all credit scores. The breakdown looks like this:
35%: Payment history
Late payments on bills will cause your FICO score to drop. Timely payments will improve your FICO score.
30%: Credit utilization
In other words, the percent of credit being used. Or, current debt owed divided by the total credit available. Opening new lines of credit, paying off debt, or receiving a credit line increase will all increase available credit, lower the credit utilization ratio, and therefore increase your FICO score.
15%: Length of credit history
This can include average age of all credit accounts, and also individual relationships with each lender.
10%: Types of credit
Different types of credit, including installment loans, revolving lines of credit, and mortgages will improve your FICO score.
10%: Recent searches for credit
Too many hard credit inquiries, which occur when applying for a credit card or loan, can temporarily hurt your FICO score.
How Credit Cards Impact Your Credit Score
You’ll notice that only 10% of your credit score is affected by recent credit inquiries, such as credit card applications. This is vitally important because many people are terrified of opening new lines of credit. They believe that new credit card applications will just destroy a credit score. That’s just not true.
In fact, the official FICO website actually has a section dedicated to “facts and fallacies” surrounding credit scores. I quote:
Fallacy: “My score will drop if I apply for new credit”
Fact: If it does, it probably won’t drop much. If you apply for several credit cards within a short period of time, multiple requests for your credit report information (called “inquiries”) will appear on your report. Looking for new credit can equate with higher risk, but most credit scores are not affected by multiple inquiries from auto or mortgage lenders within a short period of time. Typically, these are treated as a single inquiry and will have little impact on the credit score.
In other words, applying for multiple credit cards at once can have a small negative impact on your credit score. However, over time, these new lines of credit can actually improve the other more heavily weighted factors of your credit score.
As mentioned above, 30% is determined by credit utilization. When you are approved for more credit, your overall available credit increases. All else equal, more available credit will decrease your credit utilization ratio and increase your credit score over time.
Opening multiple cards also allows you to establish a longer credit history as each account ages. And if you pay the monthly balance in full, you’ll continue to build trustworthiness and a solid payment history with each account. As the years roll on, you’ll build great relationships with each bank and have an excellent payment history record.
So even if your score does slightly decrease after a few new applications, it will inevitably rebound and continue moving higher over time.
Reasons Not to Apply for Credit Cards
There are some good reasons to avoid signing up for new credit cards. These include:
- You have a low credit score. If you have a credit score that is less than 690 or so, you’ll probably get rejected when you apply for new credit cards, which means a hard pull on your credit, but no free travel. First build your credit score, then get in the game. You can begin by getting a department store credit card or something similar to make small purchases and pay them off.
- You’re planning to buy or refinance a home in the near future. All those hard credit inquiries can scare mortgage lenders. They could also slightly lower your credit score over the short term. As such, it’s best to avoid applying for credit cards 6-12 months before applying for a mortgage. That said, there are some who disagree and believe that a credit score of 760 or above pretty much guarantees the best mortgage rates. You’ll have to decide which way to go.
- You do not pay off your balance each month. I really don’t even need to talk about the high interest rates on credit cards. They are astronomical. Carrying any sort of monthly balance will completely negate the sign up bonuses, rendering this whole game moot. If you can’t manage to pay off your cards each and every month in full, then don’t worry about the rewards.
Credit Cards present a wonderful opportunity to travel the world on a very limited budget, and you shouldn’t let misguided fear stop you from applying for lucrative credit card offers.
As stated by FICO, there is a chance that your credit score will take a very slight tumble after applying for a few credit cards, but it will certainly recover and continue upward with responsible credit card use.
The additional lines of credit which lower overall utilization, the successful payment histories, and the ongoing relationships that you will establish with each bank will all increase your credit score over time and make it easier to obtain additional lines of credit in the future.