When used responsibly, credit cards can help you establish credit, and eventually build your credit history to where you have an excellent credit score. Here's how credit cards can help your credit score, as well as some of the best credit card offers that you can apply for to get started.
First, know the basics of how credit works
When you're first establishing credit, there are a few credit concepts you should be familiar with. Your credit report is essentially a record of your credit accounts and credit-seeking activities. Since this can be rather lengthy and complex, your credit report can be translated into a credit score, which is a number that tells lenders how creditworthy you are.
The most commonly used type of credit score is known as the FICO score. This is a scoring method that uses a range of 300-850 to assess creditworthiness, with higher scores being better. A score of about 700 is average, and while there is no precise range, a score above 740 is generally considered to be very good.
The precise FICO scoring formula is a closely guarded secret, but there are some aspects of it that are public information. Specifically, we know that the FICO scoring formula considers five categories of information, each of which is assigned a specific weight.
- Payment history (35% of your score)
- Amounts owed (30%)
- Length of credit history (15%)
- New credit (10%)
- Credit mix (10%)
In the next section, we'll take a closer look at each of these and how responsible use of credit cards can help build credit and eventually help you get an excellent credit score.
How do credit cards help you build credit?
Credit cards can help you establish credit, and over time, can help you maximize your credit score. Now that you know the categories that make up your credit score, let's take a closer look at how credit cards can help (or hurt) each one.
- Your payment history is the largest component of your credit score, and is also the most obvious when it comes to the potential effects of credit cards. If you get a credit card and build a track record of paying your bill on time each month, it can be a big positive catalyst to your credit score. On the contrary, late or missed payments can have a devastating effect, since payment history is more than a third of your score.
- The "amounts owed" category is a little less obvious. In addition to considering the actual dollar amounts you owe, a big factor in this category is the amounts you owe relative to your available credit, or credit limits. Lower is better, and experts say that you should keep your credit utilization to a maximum of 30% of your available credit. As time goes on, and your credit limits grow, as long as you keep your balances low, this can have a big positive impact on your score.
- If you don't have any credit yet, you don't have any "length of credit history." When you first get a credit card, this category can be a negative factor in your score, since obviously, your credit history won't be very long. In addition to the overall length of your credit history, this considers the age of your individual accounts and the average age of all of your accounts. As you keep your new credit cards open, this category will get better and better. Unlike the first two categories, however, the only way to maximize the length of credit history category is with time.
- "New credit" is another one that can be a negative factor at first. This category includes not only new credit accounts but your applications for credit, also known as hard credit inquiries. The FICO formula only considers inquiries from the previous 12 months, so it doesn't take long for this category's impact on your score to improve.
- Finally, "credit mix" refers to the diversity among your credit accounts. In other words, having a mortgage, auto loan, and a credit card can be better than just having one of those. If you're just establishing credit with your first credit card, this category might now be helping your score. However, establishing a credit card over time can open the door to other types of credit, like mortgages and auto loans.
Secured credit cards are a great place to start
Without any established credit, it can be difficult to qualify for a credit card. And other common products such as debit and prepaid cards won't do anything to help you establish credit.
For this reason, a secured credit card can be the smartest way to start building credit.
What is a secured credit card? You can find a thorough discussion of secured cards here, but in a nutshell, a secured card works just like a standard credit card in most ways. They have a spending limit, you'll pay interest on a carried balance, and secured cards are part of a major payment processing network (Visa, Mastercard, American Express, or Discover). Therefore, they are accepted just like a standard credit card.
The only major difference is that you'll need to put up a security deposit, equal to your credit limit, in order to get the card. For example, a $500 deposit will get you a secured card with a $500 spending limit. Your security deposit is placed in an escrow account, which "secures" the card.
Because you're giving the issuer a deposit, secured cards aren't considered to be particularly high risk to the issuer. So, secured cards tend to come with competitive interest rates and fees, unlike many other credit card products marketed to people with little, no, or bad credit. Some secured credit cards even have rewards programs, such as cash back.
Like a standard credit card, secured credit cards report to the three major credit bureaus, and therefore can help you build credit, as I discussed earlier. In fact, there's no way to distinguish between a secured and unsecured credit card on your credit report.
How to find a good secured credit card
There are many secured credit card products on the market, and a good place to start your search is with your own bank, as you may be able to link a credit card to your checking account, making the billing process much easier.
In addition, you should certainly compare your bank's card with several others to see which has the lowest fees and interest rates, in addition to any other perks offered. Here are some of our current favorite secured credit cards offers right now, including cards with cash-back rewards, the possibility of unsecured credit limit increases, and no annual fees.
Many secured credit cards will review your account after a certain amount of time (either automatically or per your request) and will determine if your account can be converted to an unsecured card and your deposit returned. As an alternative, once you feel that you've established credit, you can apply for a separate unsecured card, like one of our favorites.
Matthew Frankel owns shares of American Express. The Motley Fool owns shares of and recommends Mastercard and Visa. The Motley Fool recommends American Express. The Motley Fool has a disclosure policy.