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:
|Past Payment History||35%|
|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|
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.
Do you have too many cards?