How Using Your Credit Card Can Help You Rebuild Credit
Missing payments and running up debt on your credit cards can cause your credit score to plummet. But used properly, your credit card can also be one of the best ways to build your credit. By charging small amounts you can pay off in full each month, keeping old cards open to decrease your utilization ratio and increase your credit history length and following other tactics, you can rebuild credit with your credit card.
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The fundamentals of rebuilding your credit
Making your credit card payments on time every month is a key factor in boosting your credit score. If you’ve run up too much debt or missed several payments, it might be tempting to swear them off. But closing your cards may actually be a mistake that could keep your credit score from recovering.
If you are late on a credit card payment, a strong credit score can fall by 100 points or more. And late payments remain on your credit report for seven years. So, your best bet is always to avoid making late payments in the first place.
How credit cards can help you rebuild your credit
But what if you’ve already made late payments? What if you’ve run up thousands of dollars of credit card debt?
You can steadily rebuild your credit by making some changes in how you use your cards.
Make your credit card payments on time every month
Your payment history accounts for about 35% of your FICO Score, one of the most popular credit scoring models. This makes it the single most important factor in determining your score.
Making credit card payments on time each month can help you establish a new history of paying your bills on time, something that will help your credit score grow steadily.
Charge only what you can afford to pay off in full at the end of each month. Then, when your due date arrives, pay your card’s balance in full. This way, your on-time payment will be reported to the three credit bureaus, but you won’t have to pay the high interest rates you’d face when carrying a balance on your card each month.
Pay down your existing debt
Reducing the amount you owe on your credit cards can also help you rebuild your credit. This comes down to your credit utilization ratio, which accounts for about 30% of your FICO Score, making it the second most important factor.
Your credit utilization ratio measures the portion of your available credit that you are using. If you have a total credit limit of $10,000 and you have $5,000 worth of credit card debt, you have a credit utilization ratio of 50%. If you only had $2,000 worth of credit card debt, your ratio would be a far more desirable 20%.
FICO doesn’t say what your credit utilization ratio should be, but experts generally advise that you try to keep it below 30%. It’s best not to carry a balance at all on your cards, paying off all that you owe on each of your due dates. But if you do carry a balance, make sure to pay more than your required minimum monthly payment. The more debt you pay off, the better for your credit score.
Keep older cards open
It’s tempting to close old credit card accounts if you’ve paid them off and no longer use them. But that could be a mistake. Closing old cards, even if you never plan on using them, could hurt your credit utilization ratio and the length of your credit history (which is about 15% of your FICO Score).
Say you have a total credit limit of $20,000 on your credit cards and a total of $3,000 in credit card debt. You now have a pretty low credit utilization ratio of 15%. But say you no longer use two of your cards, which together have a total credit limit of $10,000. If you close those cards, your credit limit has now fallen to $10,000. If you still have that $3,000 of credit card debt, your credit utilization ratio will rise to 30%, all without you adding a single dollar to your debt.
The exception to this rule? If the cards you don’t use also charge annual fees, it might make sense to take the credit hit to eliminate paying for cards that you never use.
Alternatives to traditional credit cards
What if your credit is so damaged that you can’t earn approval for a traditional credit card? There are alternatives that you can use to rebuild your credit.
Secured credit cards
You can apply instead for a secured credit card. A secured card acts like a traditional credit card, only your credit limit is based on a security deposit that you first provide to the issuing bank. If you deposit $600 with the bank, your credit limit will be $600.
This offers protection to financial institutions: If you fail to make your payments, the bank can take the money out of your security deposit. Because of this protection, it’s easier for consumers with low credit scores to qualify for secured cards.
Secured cards can also help you build your credit. When you make an on-time payment, the bank behind your card will report it to the national credit bureaus. These on-time payments will improve your score over time. Eventually, you should be able to qualify for traditional credit cards.
Credit builder loans
Credit builder loans are another tool that can help you rebuild your credit. Unlike traditional loans, in which you receive a lump sum of money up front and then pay it back, with a credit builder loan your lender deposits a set amount of money in a savings account in your name. You then pay the money back in monthly installments, with interest. Once the money is paid back, you receive the total amount of the loan in a single sum. If your lender offers interest, you’ll also receive that.
The goal of such loans is to build your credit score. The payments you make on a credit builder loan will be reported to the credit bureaus, helping to improve your score.
Using a credit card irresponsibly is an easy way to ruin your credit. But if you find yourself in trouble, don’t be so quick to turn your back on credit cards altogether. The trick isn’t to deprive yourself of credit but to learn to use it responsibly. It’s a habit that should pay off down the road.