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Debt Management

Will Too Many Credit Cards Mean A Bad Credit Score?

With the holidays recently passed, it’s a fair guess that you were overrun with offers to sign up for credit cards, whether you’re at the cash register or checking your mail at home. Let’s take a look at two offers that always seem to make an appearance on a regular basis.

  • Clerk: “Hi, Would you like to open a credit card with Best Buy to save 15% today?”
  • Commercial Mail Offer: “Get 30,000 American Airlines Miles by signing up for the Citi AAdvantage Credit Card!”

We’re going to discuss how to make sense of choices like those above. What effect does opening a new credit card have on your credit rating? And what does it mean for your wallet when your credit score sags?

It might come as a shock, but to our mind the most important variable for the next year is your own readiness to take on loans. Below, we’ll go into why.

What is calculated in a FICO score calculation?

FICO uses a credit scoring system, which operates on a spectrum between 300 and 850 points. The exact calculation is not available for public knowledge, but there has been some information made available. This is the set of weighted factors that determine your FICO score:

Factor Weighting
Past Payment History 35%
Credit Utilization 30%
Length of Credit History 15%
Type of Credit Used 10%
Recent Credit Inquiries 10%

FICO focuses more on the recent past than the distant past

While the table above provides the basic picture of what goes into your FICO score, it’s also important to consider that your score is weighted towards your recent history overall, rather than the more distant past. If you’ve been making on-time payments on your credit cards for the last year or so, this can help minimize damage caused by past delinquencies. In the same vein, a pile of credit card payment notices that are a year old or more will do less harm today, but just a couple in recent months can be a big problem.

What is the impact of a new credit card on your credit?

A new credit card benefits your credit utilization since it lowers your total debt in proportion to available credit lines. On the other hand, it can decrease the duration of your credit history and increase your number of new credit inquiries. While it’s not fully clear how much each aspect of this choice will impact your score, its our opinion that this generally points to a small negative effect in the short term, while its long term effects have strong positive potential. In sum, opening a new credit card won’t have too much of an effect at all if you’ve got a score of 800 or more, but if you have a more limited credit history, this could push your score from the mid-range into “poor” and make it harder to obtain credit in the future.

What are the benefits of opening a card account?

Exercise careful judgment in how you use your credit card applications. Each airline mile is typically worth about a penny, so getting 30,000 of them by signing up for a new credit card means about $300 in real dollars. At the same time, the Best Buy 15% discount requires some very distinct math because the 15% savings probably won’t come out to be more than $300 unless you’re spending well over a thousand dollars on electronics.

Turn down all rewards credit cards that don’t offer some kind of immediate reward. The market is flooded with cards, like the Chase Freedom, that pay $100 or more for signing up, so unless you’re going to be getting some kind of incentive it’s not worth applying.

And how about the drawbacks of a lower credit score?

While most conversations about credit center around APRs and interest rates, the loan rate that a good FICO score can make available isn’t the most important thing to consider when thinking about the benefits of good credit. Even more important is how much money you plan on borrowing in the next year or so.

That is to say, if you’re going to be seeking a $45,000 home equity loan in the near future, having a good FICO score will be a much more significant factor than if you’re going to be looking for a $5,000 loan for your car. That’s because getting stuck with a higher interest rate on a smaller loan translates to a difference in interest payments that’s small enough to be negligible.

Input 1: Your FICO score and your interest rate

When seeking out a loan, your loan officer will base your interest rate off of a combination of criteria. A shorter loan duration and putting up collateral, as with a mortgage, can lower your rate. But the factor most within your control is your FICO score.

For instance, take a look at the table below, based on information from LendingClub’s average rates for a 36-month “debt consolidation” loan (note: these are not LendingClub’s actual rates, but our own estimates for illustration purposes only).

Credit Score Fico Score Interest Rate
Awesome 780+ 5.98%
Excellent 750-779 6.36%
Really Good 714-749 9.25%
Good 679-713 12.41%
Average 660-678 16.32%

Input 2: Loan Size

In terms of actual money that you’ll be paying, the most important factor is the amount you’re seeking to borrow. In the next table, you can see how a smaller loan minimizes the overall impact your FICO score has on how much your loan will cost you.

Loan Size Fico Score Interest Payment per Year FICO Score is 30 Points Higher FICO Score is 30 Points  Lower
$5,000 730 $483 Save $155/yr Pay extra $223/yr
$10,000 730 $965 Save $654/yr Pay extra $446/yr
$25,000 730 $2,413 Save $777/yr Pay extra $1,114/yr

Go for that new card if you’re not going to be seeking out any big loans in the near-to-middle future

In our opinion, opening 1-2 credit cards each year won’t have much impact on your credit score over the forthcoming year. In fact, it may raise your long-term credit score if you don’t have a very long credit history and keep the amount of credit you use at a low level.

If your future need for loans ranges from small to nonexistent, you should give some serious thought to the merits of an airline miles card. It’s likely that signing up for this type of card will net you a 30,000 mile reward, which translates to about $300 and thus ultimately cancels out much of the cost that comes from borrowing, according to our calculations. There are many rewards cards that have comparable deals.

But, if there is going to be a larger loan in your future, you should hold off on applying for a card or any other loan for around a year previous. In the context of taking out a loan over $25,000, its quite possible that whatever rewards your potential card offers to incentivize signing up will be outweighed by the increased interest rate that can come with a lower FICO score.

This post comes from the NerdWallet.com team of personal finance bloggers and experts in helping consumers find the best low APR credit cards.

Do you have too many cards?

Debt Management Guest Post

Should You Avoid Cash Back Credit Cards?

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Most people think of reward cards as a good thing, but in today’s guest post Michael from CreditCardForum will be discussing why they’re not right for everyone. Besides writing credit card reviews on his forum and blog, Michael also has a lot of personal experiences to share about his use of cash back credit cards and why they can lead to problems.

Twenty to thirty years ago, cash back credit cards were for the most part non-existent. But nowadays, it seems that just about every card out there is offering cash rebates, miles, points, or some other gimmick. Many assume this to be a “good thing” but that’s not always the case…

Why reward credit cards might lead to problems

Have you ever been at a store and saw something you kind of like (and don’t really need) but since it was on sale, you bought it anyways? Of course you have! Almost everyone falls for this marketing trick at least once in a while. Studies show that when something is on sale or discounted, the consumer is more likely to buy.

To a lesser degree, without a doubt there are some people that take up this “on sale” mentality when using cash back credit cards. If their card is giving a 5% rebate on gas, groceries, drugstores, or whatever category it may be, they may be inclined to spend more. I consider myself extremely disciplined when it comes to finances, but even I am guilty of doing this once in a while.

For example, I was at Staples a few weeks ago and I knew I could have gotten the paper cheaper at Target, but I said to myself “Well my AT&T Universal credit card gives 3% at office supply stores, so I’ll get it here.” Thinking like that is actually quite ridiculous – the computer paper would have been about 15% cheaper at Target, which definitely trumps the pitiful 3% rebate from my credit card!

The lesson?

The bottom line is reward cards encourage many people to spend more than they normally would. Or, as in my case, they can lead to people shopping at more expensive stores (i.e. buying supplies at a drugstore because of the higher rewards there, when in reality a place like Target, Wal-Mart, etc. would be significantly cheaper for those items).

If you reward credit cards cause you to do these same things, it may be best to avoid using those cards altogether. Remember, saving 5% does not make sense if it’s causing you to spend 20% more!

When are they okay to use?

If you’re extremely disciplined with reward cards, they can be a useful financial tool. For example back a few years ago when I was dirt poor, I had no choice but to be disciplined with every penny spent. I definitely fell under the income bracket that would be classified as poverty, so for me it was all about coupons and discounts when buying necessities. I would use my credit card for the 5% rebates on groceries and gas, but that would never encourage me to buy or spend anything extra, because my money was so tight I simply didn’t have that luxury even if I wanted to do so. In that situation it totally made sense, but not everyone would have handled it the same. If the rewards would have encouraged me to spend more, the outcome could have been disastrous.

Have reward cards ever influenced your spending?

photo credit: peapodsquadmom

Banks around the world are beginning to get the message. HSBC Australia can set up a low credit limit and an automatic notification if you hit the limit. Get the limit low enough and it becomes an early warning signal.

Debt Management Guest Post

Everything You Need To Know About Credit Agencies


Creative Commons License photo credit: paalia

Today, Mr Credit Card is going to give us a quick run down on credit bureaus and credit scores. Aside from reviewing credit cards, Mr Credit Card has also written about identity theft protection reviews. Please check out his site for the latest credit news

A couple of hundred years ago if you wanted a loan you might have to present your case to the lender for why you are “good for it”. If the lender didn’t know you, they might ask about you around town to see what your financial reputation was. Today, the Credit Agencies fill that role in an electronic way. Virtually all people in the United States have a file with Equifax, TransUnion, and Experian, the three major credit agencies. For a long time, the file consisted solely of the details of the accounts you hold with lenders that report to one of these agencies. For instance, your bank might report your credit card account, when it was opened, what your balance is, what your credit limit is, and what your payment history has been. Quickly interpreting all of this information became a challenge for financial institutions and the credit agencies boiled it down to a single number known as a credit score.

What This Means To You?

Every time you apply for credit, a record is sent to the credit agencies. If you take out a loan, or obtain a credit card they are informed as well. Over time, a picture of all of this information, including your payment history becomes your credit score. Your credit score is used by lenders to determine if you will be granted loans in the future. For that reason alone, it is important to maintain a good credit score. Unfortunately, credit scores are now being used for all sorts of reasons that have nothing to do with loans. Employers are increasingly using credit scores to screen applicants. Insurance companies have also been known to set rates based in part on customer’s credit scores. While I am strongly against such uses, everyone needs to be aware of this reality when making decisions that can affect your credit score.

How Your Credit Score Is Determined

The credit agencies actually have a policy of specifically not telling the public the exact formula they use to generate credit scores. Nevertheless, observers have deduced an approximation of how the score is computed. As one might expect, payment history is the most important factor making up 35% of the credit score. 30% is determined by debt ratio. Debt ratio is the amount of debt you have relative to the amount of credit your currently have. It might not be intuitive, but having more available credit actually increases your credit score as it lowers your debt ratio. 15% of your score is determined by the length of your credit history. Therefore, it is best to keep credit cards open for a long time, rather than cancel unused cards, especially if there is no annual fee. Of the rest, 10% is composed of the types of credit you have been extended, and 10% from the number of recent credit inquiries you have.

How To Increase Your Credit Score

Obviously, paying your bills on time is by far the most fundamental thing that you need to master to improve your credit score. Less obvious is the strategy of hanging on to your accounts for a long time. This will improve your credit history and debt ratio. Also, do not apply for credit too frequently. Many shoppers cannot resist the lure of the 10% discount frequently offered when opening up a store charge card a many chains. As a rule of thumb, I limit my credit card applications to situations where I am offered a sign up bonus worth at least $200. Anything less simply isn’t worth the hit on my credit. Finally, double check your credit reports regularly. Errors in credit reports are extremely common, and credit bureaus have little incentive to correct them. When requesting a copy of your credit report, go directly to the three major credit bureaus or through www.annualcreditreport.com, the only site that will actually offer you a free report (though the credit bureaus will always be trying to sell you their “credit monitoring services”). Many other similarly sounding sites exist to sell you some product or service in addition to supplying you your credit report. By law, you are required to be given a copy of the report every year, and you do not have to purchase anything to get it.

Having a Good Credit Score Saves You Money

With the huge impact that the three main credit bureaus have on society, it is worth noting that having a good credit score can save literally thousands of dollars in your mortgage interest for example. Even if you are not a credit addict, it always pays to maintain a good credit score as soon as you can.

The easiest way to build a credit profile is simply to use a credit card. But there is a big caveat here. You have to use it responsibly. That means paying your bills in full and using it for expenses you would have to make anyway (and not on impulse purchases). A college student (if responsible) can start building their credit with a student credit card. If you have no credit, you can start of with a secured credit card.

Your credit report is an important part of your reputation, and a good credit score is an extremely valuable asset. Learning how to maintain a good credit score is a key skill for financial survival in today’s economy.

Debt Management Guest Post

Is Debt Snowball An Effective Debt Reduction Strategy

This is a guest post by David Brown, a content writer with Oak view law group. He writes on a variety of finance related topics with a strong focus on debt.

Are you submerged in debt and desperately looking for a way out of the debtors prison? Well, it is certainly possible for you to get out of the red zone without filing bankruptcy or consolidating your debt. The modern era we live in offers far too many strategies to combat debt. One of the better known approaches to eliminate debt is debt snowball. Can this approach really lead you to a debt free destination? Let’s discuss.

What is debt snowball?

The concept of debt snowball has been popularized by financial guru Dave Ramsey. Debt snowball is a process by which you list all your debts from lowest to highest and attack the lowest debt first. You need to pay minimums on each bill except for the lowest one. Pay as much as you can towards the lowest debt so that you can get rid of it as soon as possible. Next, you move on to the second lowest debt and the process continues till you are free from the rib crushing, spine tingling clutches of debt.

What are the advantages of debt snowball?

“Personal finance”, Dave Ramsey correctly points out, “is 20% head knowledge and 80% behavior”. Debt snowfall is based on this view. It rightly assumes that paying off smaller debts gives a sense of victory which motivates people to pay off all other debts.

It is relatively easy to pay off bigger debts using debt snowball method. Here you clear the smaller debts first. So by the time you reach the bigger debts, the extra amount that you can pay towards them increases. Consequently, it is possible to eliminate them quicker.

Another advantage of debt snowball method is the reduction of the total amount owed to creditors in a single month. This can save your neck in case you encounter an unforeseen situation like loss of job or medical emergency.

Debt snowball has often been compared with debt avalanche theory by which you try to eliminate the debt with the highest rate of interest first. This approach is mathematically better than debt snowball as you have to pay the least amount of interest. Nonetheless, the debt with highest interest rate can also be the one with the highest balance. This means it will take a long time to pay it off which can have a psychological impact on you. It is highly possible that you will try to get rid of it for several months only to give up because of a feeling that you are getting nowhere. This is where debt snowball scores over debt avalanche. The “quick wins” you get with the former, gives you hope-something very important, sometimes more important than money.

Some criticisms against debt snowball

It has been pointed out that by emphasizing on human psychology, debt snowball puts mind over matter which can result in monetary loss. As you focus on the debt with smallest balance instead of the one with highest interest rate, you have to pay more money in the long run. Thus, your “motivation” comes at the cost of some extra bucks.

Secondly, debt snowball does not take into account the difference between secured and unsecured debt. Problems often follow if secured debts are not addressed at an initial stage- foreclosures and repossessions being at the worst end of the spectrum.

Is debt snowball the right choice for you?

Debt snowball is a simple debt reduction method which is suitable for people who have a wide range of balances. It gives you tangible results and motivation which is missing from other similar approaches. While is it most effective for people who need some encouragement in the form of quick results, individuals with a lot of patience will benefit more with avalanche approach because it is cheaper.

Debt snowball can certainly help you to climb up from the trenches. However, you should remember that it cannot make you debt free with the wave of a wand. But if you stick to it till the end then your patience will be certainly rewarded.