Credit cards can boost or sink your credit score, a financial tool that opens doors to many good things in life – such as favourable bank loans for your dream car and home, as well as competitive interest rates. Find out what you should do and what to avoid so you can achieve a healthy credit card balance and credit score.
Your credit cards and credit scores have a significant influence in shaping the state of your finances. A credit card enables you to shop and spend without the inconvenience of carrying around large amounts of cash, while your credit score – a three-digit number which represents how likely you are to repay debt in full and on time – is among the key factors that will be taken into consideration when the banks are reviewing your loan or credit card application.
As you shall see, these two credit-related financial tools (credit cards and credit scores) are closely connected. Since financial institutions do not know you well enough to evaluate your level of debt repayment, they use your credit score to gain a better understanding of the potential risks that come from lending money to you. So having a strong score improves your chances of getting a bank loan or credit card. You’ll also be able to leverage the banks for better financing options such as lower interest rates or flexible payment periods.
To improve your credit score, you’ll need to build up a record of timely bill payments, minimal debt and responsible borrowing, which is also known as your credit history, and that’s where your credit card usage can significantly impact your score.
The number of credit cards you have, whether you pay your credit card bills on time, and the amount of credit card debt you currently owe are some of the most important details in your credit history, and these records will turn up in the credit reports generated by credit reporting agencies. Based on your credit reports, the agencies will then calculate your credit score according to these factors:
- Payment history (a record of the payments you have made for credit card bills, bank loans and other debts)
- The amount of debt you have in comparison to your credit limit
- The length of your credit history (how long you’ve used credit)
- The types of accounts you have (e.g. home loan, car loan and credit cards)
- Recent credit activity (if you have recently been approved for loans/credit cards)
Now, let’s go into further detail about how your credit cards can affect your credit score.
Huge credit card debts can negatively affect your debt utilisation ratio, and subsequently your credit score.
Late or missed payments
When you’re late in paying off your credit card bills, the outstanding balance in your credit card statement will accumulate interest at an alarming rate – with banks charging an average of 11% to 18% of interest.
On top of that, a late payment fee will also be charged to you. Even if you can afford the minimum amount (the smallest amount of money you have to pay every month to keep your credit card account in good standing), there will still be interest charged to any unpaid amount.
Thus, your debts will pile up while your credit limit remains the same, and this, in turn, will affect your debt utilisation ratio, a vital component that helps determine your credit score.
What is debt utilisation ratio?
As part of the process to evaluate your credit score, credit reporting agencies will take into account the debt utilisation ratio in your monthly credit card statements. This ratio – which represents the percentage of available credit you’re currently using – is calculated based on your present amount of credit card debt compared to the credit limit of all your cards combined.
It’s also important to keep your debt utilisation ratio below 30% in order to achieve a good credit score. So if your combined credit limit is RM10,000, you should have a debt utilisation of no more than RM3,000.
A high and unhealthy debt utilisation ratio will cause a dip in your credit score, as your payment history and how much money you owe make up a huge chunk of your score. According to credit reporting agency CTOS, 45% of your credit score will be based on your payment history while the number of credit facilities and the amount you owe determine 20% of your score.
Keep your debt utilisation ratio low by spreading out your purchases across numerous cards rather than one.
Having multiple credit cards
Having several credit cards can either have a positive or negative effect on your credit score. It depends on how you use them.
Lower debt utilisation ratio
Here’s one way to improve your debt utilisation ratio and subsequently your credit score with multiple credit cards: Try maintaining your current amount of spending (despite having new cards). This way, your monthly credit card debt will remain the same while you enjoy a higher combined credit limit with every new card you receive.
For example, you may have five credit cards, and each one comes with a RM5,000 credit limit. These five cards will give you a combined credit limit of RM25,000. If you typically only charge RM5,000 to your default credit card each month while rarely using the other cards, your debt utilisation ratio is only 20%. (Remember, the lower your debt utilisation ratio, the better it is for your credit score!)
How to calculate your debt utilisation ratio for the scenario above:
RM5,000 ÷ RM25,000 x 100% = 20%
Harder to keep track of your expenses
However, it can also be harder to keep track of your spending when you have multiple credit cards. If you spend beyond your means with the additional cards and you’re unable to pay your bills on time, your debt utilisation ratio will go up while your credit score could come crashing down.
Cancelling a credit card
You may have signed up for too many credit cards because the special offers that came with them were so enticing. Maybe you’re finding it tough to keep track of your spending with multiple credit cards. So you’ve decided to cancel some of your cards. Just hold on a second, you might want to consider how cancelling a credit card will affect your credit score before doing so.
Higher debt utilisation ratio
By closing a credit card, you might also be increasing your debt utilisation ratio. Imagine the scenario highlighted in the previous point, where you have five credit cards with a combined credit limit of RM25,000. As you consistently have a balance of RM5,000 on just one card, your debt utilisation ratio is 20%. Now, let’s say you’re cancelling three credit cards...
With 5 credit cards
(total credit limit: RM25,000)
With 2 credit cards
(total credit limit: RM10,000)
|Debt utilisation ratio with RM5,000 monthly usage||RM5,000 ÷ RM25,000 x 100% = 20%||RM5,000 ÷ RM10,000 x 100% = 50%|
|What you’ll end up with||Lower debt utilisation ratio; will help improve your credit score||Higher debt utilisation ratio; negative impact on your credit score|
Left with two credit cards, your new debt utilisation ratio would have risen to an unhealthy 50%, and this could cause your credit score to drop.
Closing a card with a good payment history
What’s more, if you’re cancelling a card with a good payment history, you’ll also be permanently deleting a proven track record of prompt bill payments. This will have a negative impact on the credit reports and ensuing credit scores that are generated by credit reporting agencies.
On the other hand, if you’re burdened by heavy credit card debts and you’ve decided that cancelling your credit cards is the best option, then you should do so. At this point, keeping a credit card could only entice you to spend more, and consequently increase your debts.
We hope this explanation will give you a better understanding of credit card usage and how it can affect your credit score. So remember to spend wisely and pay your bills on time!