You don't want to mess up your credit score or pay a fortune in credit card interest. Follow these rules to make sure you use credit wisely.
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Credit is an important tool. Earning a good credit score means you'll be able to borrow for things you need, whether that means getting a car loan or a mortgage or just being able to use a credit card to buy items and earn rewards.
Credit can help you build wealth, if you use it wisely. When you get a mortgage and pay it down, for example, you build equity in your home. It can also help you to appear trustworthy to all those who check your credit, from your landlord to a potential employer to a company you want to borrow from.
Unfortunately, if you don't use credit wisely, it can cause you major problems. You could hurt your credit score, which means you may be denied the ability to borrow or rent an apartment. Or, you could end up paying much more in interest on future financial transactions. If you use credit unwisely and end up in debt, it's also very difficult to get your finances back on track.
To make sure you're using credit in a financially responsible way that helps improve your credit score and your financial life, follow these four credit rules.
1. Pay your bills on time
Paying your bills on time is essential to show you're a responsible borrower. A single late payment could cause your credit score to fall by as much as 110 points if you had a good credit score before paying late.
Paying late sends up red flags that suggest you may not meet your financial commitments. Future lenders will be wary of giving you money if they don't think you can repay it. You'll also likely be hit with a late fee from your lender. And, if you paid a credit card late, your APR could be raised to a much higher penalty APR, which would mean your interest costs rise.
The later you are in paying your bills, the more your credit score will be damaged and the more severe the consequences will be. If you don't end up paying at all, you could find yourself facing serious consequences such as a credit card company suing you, a car loan lender repossessing your vehicle, or your mortgage lender foreclosing on your home.
2. Keep your utilization at 30% or less
When you have a credit card, you're given a line of credit. That's the amount of credit you have available to you. You don't have to max out the entire line of credit and borrow as much as you're allowed to.
In fact, you shouldn't max out your credit card. Instead, you should use just a small portion of the credit available. Not maxing out your cards makes it easy to borrow in case of an emergency and it also helps you increase your credit score.
One of the key factors in determining your credit score is your credit utilization ratio. Your credit utilization ratio is the amount of available credit you've used. So, if you had a credit card with a $1,000 line of credit and charged $300, your credit utilization ratio would be 30% -- but if you charged $500 your utilization ratio would be 50%, and if you charged $1,000, your utilization ratio would be 100%.
Using 30% or less of your available credit is ideal to earn the best credit score, as this shows you're not overusing your cards and that you can be responsible with how much you borrow.
3. Don't charge more than you can afford to pay back
When you use credit cards, it sometimes doesn't feel like you're spending real money. This can cause problems because you may not have the funds available to pay off the balance when your bill comes due.
You don't have to pay off your credit card balance each month. In fact, creditors would rather that you don't. You can pay just a minimum payment, which is usually equal to the lesser of a flat fee such as $25 or a set percentage of your card balance, such as 2% of the total you owe.
The problem is, if you don't pay off your credit card balance in full when the statement comes, you'll owe interest. And, if you make only the minimum payments, you'll end up paying a fortune in interest. If you have a $1,000 credit card balance on a card charging 15% interest and you make a minimum monthly payment of $20, it would take you 117 months and cost you $1,851.03 to pay off the balance.
You'd be in debt for almost 10 years and would pay more than $850 in interest costs over that time period. When you pay interest on purchases, each item you buy costs more and your money doesn't go as far because you're sending so much extra to lenders. You don't want to get into this situation -- so don't charge more than you have the cash to pay off when the statement comes.