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We devote a significant amount of time to talking about travel rewards credit cards here at TPG. By utilizing top sign-up bonuses and strategically swiping your cards for a variety of purchases, you can unlock fantastic redemptions like premium-class flights and luxurious hotel rooms. However, there are a number of misconceptions out there when it comes to credit cards, so today I’ll continue our new series that debunks these myths and allow you to begin planning for your next vacation. I started with having too many cards and closing a card you don’t use, and today I’ll move on to another hot topic.
Myth #3: Applying for a credit card will permanently impact my credit score.
Many of my friends and family members think I’m crazy for opening several new credit cards every year. The most common refrain goes something like this: “Doesn’t that just wreck your credit score?” It’s true that when you apply for a new credit card (or any new line of credit for that matter) the issuing bank will run a hard inquiry on your credit history. Generally speaking, each new hard inquiry will drop your credit score by 2-5 points.
However, these inquiries will not have anywhere near a permanent impact on your FICO score, the one most frequently used to determine your creditworthiness. Here’s a direct quote from myFICO.com:
In other words, even if your new hard inquiry drops your score by 5 points, it’s only a temporary drop. Not only will it no longer impact your credit score after a year; it’ll also be wiped from your credit report entirely within 2 years.
But even this analysis falls short of reality when it comes to applying for credit cards, since it ignores all of the positive things that come with a new line of credit. As I mentioned in previous entries in the series, it’s essential to understand the five factors that contribute to your FICO score:
- Payment history
- Amounts owed
- Length of credit history
- New credit
- Types of credit used
Remember that not all factors are created equal, and these five are weighted based on how important they are to your score:
For starters, you’ll notice that new credit represents the smallest piece of the pie, making up just 10% of your overall score. In addition, the two largest pieces of the pie (payment history and amounts owed) can wind up canceling out any temporary drop in your score thanks to a new hard inquiry. Let’s take a closer look.
Payment History
As you see above, your payment history is the most important factor to your FICO score. When you open a new credit card, the major reporting bureaus will identify the new hard inquiry on your credit report, but they’ll also begin reporting your payment history. Paying your balance in full and on time will have a positive impact on your score, and given the chart above, will proportionally be much more important than a small (and temporary) drop in your score due to a new hard inquiry.
Amounts Owed
The second most important factor in your FICO score is the amounts owed, commonly referred to as your credit utilization rate. This looks at how much of your credit you are actually using and is typically expressed as a percentage. Here’s the calculation:
Keeping this number low shows issuers that you can effectively manage your credit lines and aren’t at risk of overextending yourself.
When you apply for a new card, you’re adding to the denominator of the above equation without impacting the numerator. If you currently have a total of $100,000 of credit across your cards and add another one with a $20,000 limit, you’re now spreading your balances out across a credit line that’s 20% larger. As a result, your utilization drops and you become even more attractive to card issuers. Since this factor alone accounts for nearly a third of your FICO score, improving it can have a proportionally larger impact on your score than the temporary drop from a new hard inquiry.
For some additional tips on how to successfully manage your credit cards, be sure to check out my post on Ten Commandments for Travel Rewards Credit Cards.
Bottom Line
There are a lot of myths when it comes to applying and using credit cards, especially when it comes to the impact these applications have on your credit score. Many worry about how applying for new cards can impact their score in the long run. In reality, a new hard inquiry will only temporarily appear on your credit report, and the positive benefits you’ll get from your payment history and amounts owed can easily outweigh this temporary impact. While you should always stay within your means when applying for and utilizing credit cards, don’t avoid new applications simply because you’re afraid of how they’ll impact your credit report.
For additional information on your credit score and credit cards, check out the following posts:
Source: thepointsguy.com