Credit Scores and Avoiding Credit Card Debt
Jayden is 18 and wants to rent his first apartment. The landlord says, "I'll need to run your credit." What is the landlord looking at, and why does a number between 300 and 850 matter to a landlord, a car dealer, or even a phone company? In this page you will learn what builds that number, how to protect it, and how to keep credit card debt from growing out of control.
What a credit score is and what builds it
A credit report is a record of how you have borrowed and repaid money. A credit score is a number, usually from 300 to 850, that sums up the report. Lenders use it to guess how risky you are as a borrower. A higher score usually means a lower interest rate (APR), so the same loan costs you less.
The most widely used score is the FICO score. It is built from five factors. The percentages are approximate.
| Factor | Approx. weight | What it asks |
|---|---|---|
| Payment history | 35% | Do you pay on time? |
| Amounts owed | 30% | How much of your available credit are you using? |
| Length of credit history | 15% | How long have your accounts been open? |
| New credit | 10% | Have you applied for a lot of credit lately? |
| Credit mix | 10% | Do you handle different kinds of credit (cards, installment loans)? |
The two biggest factors, payment history and amounts owed, make up about two-thirds of the score. That is where you get the most return for your effort.
Name the five main factors that make up a FICO credit score. Identify the two factors that usually have the largest effect on the score.
Name the five main factors that make up a FICO credit score. Identify the two factors that usually have the largest effect on the score.
Credit reports and the three bureaus
Your credit report is collected by three nationwide credit bureaus: Equifax, Experian, and TransUnion. It lists your accounts, balances, payment history, and inquiries. Each bureau may hold slightly different information, so the three reports can differ.
You are entitled to free reports from each bureau at annualcreditreport.com, the official site. Check them regularly for two reasons:
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You can catch errors, such as an account that is not yours or a payment wrongly marked late. You can dispute errors with the bureau.
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You can spot signs of identity theft early, such as a card you never opened.
What is a credit report? Name the three nationwide credit reporting agencies (credit bureaus). Explain how a consumer can check their reports for free and why doing so…
What is a credit report? Name the three nationwide credit reporting agencies (credit bureaus). Explain how a consumer can check their reports for free and why doing so is a good habit.
Credit utilization
Credit utilization is the share of your available credit that you are using:
$$\text{utilization} = \frac{\text{balance}}{\text{credit limit}} \times 100$$Lower is better. A common guideline is to stay below 30%, and lower still is even better. Why? A person who has used nearly all of their credit looks like they may be stretched thin.
Liam has a credit card with a limit of $\$1{,}500$ and a current balance of $\$450$. Calculate his credit utilization ratio as a percent. Is it below the commonly…
Liam has a credit card with a limit of $\$1{,}500$ and a current balance of $\$450$. Calculate his credit utilization ratio as a percent. Is it below the commonly recommended level of $30\%$?
Olivia has two credit cards. Card A has a limit of $\$2{,}000$ and a balance of $\$1{,}200$. Card B has a limit of $\$3{,}000$ and a balance of $\$300$. Find her…
Olivia has two credit cards. Card A has a limit of $\$2{,}000$ and a balance of $\$1{,}200$. Card B has a limit of $\$3{,}000$ and a balance of $\$300$. Find her utilization on each card and her overall utilization. How much total would she need to pay down to bring her overall utilization to $30\%$?
Why minimum payments are a trap
Credit card interest is quoted as an APR (annual percentage rate). Interest is charged on your balance, usually every month, so a quick estimate of one month's interest is:
$$\text{monthly interest} \approx \text{balance} \times \frac{\text{APR}}{12}$$The minimum payment is the smallest amount you must pay to stay in good standing. If you pay only the minimum, most of it can go to interest, and the balance barely falls. If you carry a balance, you also lose the grace period, the time between a purchase and the due date when no interest is charged on a balance you pay in full.
A useful special case: if you pay only the monthly interest, the balance never changes, because the payment is used up by interest. To make progress, you must pay more than the interest.
A credit card has a balance of $\$2{,}400$ and an APR of $24\%$. The minimum payment is $2\%$ of the balance or $\$35$, whichever is greater. Find the minimum payment…
A credit card has a balance of $\$2{,}400$ and an APR of $24\%$. The minimum payment is $2\%$ of the balance or $\$35$, whichever is greater. Find the minimum payment for this month. Estimate the interest charged for one month by dividing the APR by 12. How much of the minimum payment reduces the balance? What does your answer show about paying only the minimum?
Paying off debt: strategies
Once you have card debt, the goal is to pay it off and not add new debt. Pay at least the minimum on every card, then put every extra dollar toward one card. Two popular methods differ in which card gets the extra money:
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Avalanche method: target the card with the highest APR first.
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Snowball method: target the card with the smallest balance first.
The avalanche method saves the most interest, because the most expensive debt disappears first. The snowball method may cost more, but the quick win of closing a small account keeps many people motivated. The best method is the one you will actually stick with.
Other ways to avoid or reduce card debt:
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Make a budget and pay with a debit card or cash for things you can't afford to pay off at the end of the month.
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Pay the full statement balance each month to keep the grace period.
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Set up automatic payments so you never pay late.
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Build a small emergency fund so a surprise bill doesn't go on a card.
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Ask the issuer for a lower APR, or consider a lower-rate balance transfer, but read the fees first.
Ethan has two cards. Card X has a balance of $\$1{,}000$ at $28\%$ APR. Card Y has a balance of $\$600$ at $15\%$ APR. He can pay an extra $\$100…
Ethan has two cards. Card X has a balance of $\$1{,}000$ at $28\%$ APR. Card Y has a balance of $\$600$ at $15\%$ APR. He can pay an extra $\$100$ per month beyond the minimums. Explain which card he would target first under the avalanche method and which under the snowball method. Which method saves more interest, and why?
Daniel owes $\$3{,}000$ on a credit card with a $20\%…
Daniel owes $\$3{,}000$ on a credit card with a $20\%$ APR. Estimate the interest charged in one month. Suppose he pays only that amount each month. What happens to his balance over time? Now suppose he pays a fixed $\$150$ per month. How much of the first payment reduces the balance? Write a short argument with at least three strategies he can use to eliminate the debt and avoid new credit card debt.
Becoming a lower-risk borrower
A low-risk borrower has a high score and a track record of repaying. You can build one with a few habits that line up with the FICO factors:
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Pay on time, every time (payment history, about 35%). A payment 30 or more days late can be reported and stays on your report for years. Use automatic payments or reminders.
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Keep utilization low (amounts owed, about 30%). Pay down balances and aim under 30%.
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Keep old accounts open and avoid unnecessary closing (length of history, about 15%).
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Apply only when you need credit (new credit, about 10%).
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Show you can handle different kinds of credit over time, but don't borrow just for the sake of it (credit mix, about 10%).
Thinking in terms of weights helps you rank problems. A late payment hurts more than one new application, and high utilization usually hurts more than a short history, though the exact effect depends on your whole report.
Priya has a credit score of 640. Her credit report shows a payment that was 45 days late, a credit utilization of $85\%$, an oldest account that is 2 years old, and…
Priya has a credit score of 640. Her credit report shows a payment that was 45 days late, a credit utilization of $85\%$, an oldest account that is 2 years old, and three credit card applications in the last two months. Rank these four items from most to least harmful to her score. Then design a plan with at least three strategies to become a lower-risk borrower, and explain the reasoning behind each strategy.
Summary
Back to the start: the landlord runs Jayden's credit because the score predicts how likely he is to pay on time. Every habit on this page makes that prediction better.