While this advice may seem counter-intuitive, from my experience, opening a credit card is the first step to rebuild a less than stellar credit score. Keep in mind that credit profiles with a FICO bank card score under 620 will not get approval for your standard unsecured credit card, so a secured credit card would be necessary. Because the scoring model for FICO weights revolving accounts almost 2x more than installment accounts, acquiring a credit card that can be used and paid on time monthly is a logical first step to rebuild your credit.
In 10 years of working in the industry, I have yet to see anyone with a FICO credit score over 680 without a credit card reported. Why is that important? While you are disputing charges and working toward other goals, you have the opportunity to demonstrate that you can meet your current financial obligations. Of course, if you subscribe to the idea that owning credit cards are always bad and owning them should be avoided at all costs, consider this; it is not nearly as bad as the inability to finance your basic life needs.
Our country’s financial system is geared toward borrowing, evidenced by FICO’s model. That’s why I often have to clarify the difference between your best financial strategy and your best credit strategy. From a credit strategy standpoint, this advice is solid, proven and relatively easy.
What is a secured card and how do they work?
Secured cards are ideal for the consumer with damaged credit, or someone new to credit. Bank issuers of secured credit cards have systems in place to make sure their investment is protected. Here is what a secured card is, and how it works:
What is a secured card?
A secured card is a credit card designed for a consumer with bad credit or a thin credit file. They require you to pay a refundable deposit, which secures your available credit, usually several hundred dollars. Because having a credit card is the easiest and fastest way to build credit, a secured card can be worth your while. Just make sure the issuing bank will report your credit behavior to the 3 major credit bureaus.
How do secured cards work?
- What is it? A secured card is a credit card that requires a refundable deposit in exchange for a credit limit, typically $200 or more. Most credit cards are unsecured credit cards, which means a security deposit isn’t required.
- What should you watch for? Even if a secured card has no annual fee, you’ll need to check for other kinds of fees, including late fees and returned payment fees.
- How do I get approved? Check your credit score and the bank’s requirements to make sure you are likely to be approved. Be honest on your application, because if you are caught lying, you can lose the account.
- What do I do first? If you are approved, you’ll be required to pay the refundable deposit. Then, you’ll be approved for a credit limit, typically starting at $200.
- How should i use it? Even if your credit limit is $500, that doesn’t mean you should spend the limit. If you carry a balance of $250, that means your utilization ratio is 50%. You want your ratio to be as close to zero as possible, for credit-building purposes. Also, you need to pay on time each month, again to ensure you are building your credit which is the purpose of the card.
- Rinse and repeat. Check your credit score after several months and see if you qualify for a better card. Some cards increase your credit limit after several months of on-time payments. For good measure, check your credit reports, as well, looking for errors or mistakes that need to be corrected.
- Time for an upgrade? There are options to obtain an unsecured card after 8 months of good credit habits.
How do you use a secured card?
You can use a secured credit card in the same way you use an unsecured card – simply present the card to the retailer to make a purchase, provided the merchant accepts the network displayed on the front of your card (Visa, Mastercard or Discover). You can use the card for all manner of purchases such as renting a car or hotel room; and in some cases all while obtaining rewards.
However, because the credit limit is typically only several hundred dollars, it’s worth your while to limit use of the card to one or two small purchases a month, then pay off the bill in full before the due date. This will allow you to build your credit more effectively by keeping your balance low compared to your available credit, called your utilization ratio. Here’s how it works:
If you have $500 in available credit, and you have a balance of $250, your utilization ratio is 50%, which is way too high. You want to keep your ratio as close to zero as possible, at least below 30%.
Because you don’t know exactly when during the month that the card issuer will report your credit habits to the three credit bureaus, it’s a good idea to pay in full several times a month, keeping the utilization ratio as low as possible. My advice is to create three reminders each month to ensure that you pay on time and often.
Do secured cards really help your credit?
Secured credit cards can help your credit, if you pay in full and on time each month and you make sure the issuing bank reports your credit habits to the three major credit bureaus. By paying in full and on time, you are building your credit history as well as improving 65% of your score with a single action. If you ensure that your credit habits are being reported, then you know that the credit bureaus have what they need to share with the credit score models and lenders.
Experian polled consumers to find out what were their primary reasons for taking out a card. Surprisingly for some, 32% of consumers get a credit card to build credit, while 31% get a card to build their credit limit; which are both great reasons for getting a secured card. As you can see from the results, building credit and improving one’s credit limit were two major reasons.
Primary reasons for credit cards…
- 68% – Purchase things I need
- 42% – Earn reward points
- 37% – Provide an emergency cushion
- 32% – Build my credit
- 31% – Improve my credit limit
- 31% – Provide extra money for things I want
- 16% – Pay off other debt
Source: Experian survey
Other Resources. Other Options.
I have often found www.creditcards.com to be extremely informative for many different reasons.
If your scores are lower than 680, there are still credit card options for you. I often resource www.creditcards.com to compare and contrast the differences before advising which card to open.
If you would like to know more how opening a credit card may be your best credit strategy, reach out via email or give me a call. I have a list of preferred secured credit cards to work with and will happily discuss the pros and cons of each lender.
Closing Cards – Is there a downside?
In summary, I want to ensure you that there is NO negative impact to closing a tradeline. Closing a credit card can improve or decrease your credit score. This is solely based on whether this card improves or decreases your average credit history. If you close a six month old credit card and you have several other older accounts open, this will increase your score. However, let’s say the credit card in question is six years old. This card is one of your oldest accounts but has a high rotational interest. Due to this fact, you are balance transfering to a 0% APR offer on a new credit card. This will negatively impact your score based on the fact you are reducing your average credit history. You are actually negatively impacting it 2x by closing and old account AND opening a new account.
Your credit score will decrease temporarily anytime you open an account of any type with 2 exceptions. 1) When you open your first tradeline, and 2) When you open your first revolving account.