Used responsibly, a new credit card account can help you build your credit score. But what exactly does that mean?
A Money Talks News reader recently sent me the following question:
I’m hoping to buy a home in the next year or so. My credit is good, but I want to improve my score even further to get the lowest possible interest rate on a loan. Will opening a new credit card help or hurt my cause?
The answer to Sarah’s question requires more of an explanation than a simple yes or no.
Here’s the deal with opening a new credit card account: In the very short term, opening a new account will cost you a couple of points on your credit score. Why? Because getting approved for a credit card requires a “hard pull” of your credit profile by the card issuer. This happens every time you apply for a loan or credit card, and is the reason you might see your credit score drop a few points after a credit card or loan approval.
Generally, the drop in your score is marginal and easy to rebound from. That said, it’s worth noting that a hard pull of your profile remains on your credit report for two solid years before falling off. A soft pull, on the other hand, is when you pull your own score and has no effect – positive or negative – on your credit score.
So, in the short term, opening a new credit card will negatively affect your score, albeit very little.
The long-term effects of opening a new credit card account can be extremely positive, assuming you make on-time payments each month and keep your balance low. In fact, opening a new credit card account improves your score in more ways than one:
1. Improves your payment history. According to FICO, more than a third of your credit score is made up of your payment history. A pristine payment history means zero late or missed payments. The longer you go without missing a payment, the better your credit score will be. Adding a new card and making on-time payments each month will enhance your payment history and thus your score.
2. Extends your available credit line. FICO has said that the second-most important factor when determining your score is your credit utilization ratio. This is the amount you owe relative to your total available credit line.
When you add a card to your credit profile, you’re extending your total available credit line and thus lowering that all-important credit utilization ratio. Ideally you want to keep this ratio below 10 percent, meaning if you have a total credit line of $1,000, you should never owe more than $100. This is another reason why it’s extremely important to keep your credit card balance low.
3. Diversifies your credit profile. Finally, opening a new credit card account diversifies your profile if you haven’t had a credit card before. Having different types of credit — credit cards, home or car loans — is another factor that can raise your credit score.
While you might see an initial drop in your credit score upon approval of a new card, the long-term positives far outweigh the short-term negatives associated with opening a credit card account. Opening a new card will be especially useful for Sarah because she has a year to improve her score.
So long as you keep your balance low and your payment history spotless, adding a new credit card to your profile will improve your score in more ways than one.