After recent articles on how to start travel hacking and the best travel rewards programs for non frequent-fliers, we’ve received a few questions from readers wanting to start taking advantage of credit card rewards for the first time.
One reader asks:
I had credit card debt in the past, so the idea of opening a new card sounded crazy. Now that I’ve paid off my debt, I’ve have started thinking about using a rewards card (maybe the REI card, I buy so much gear from there!) but I’m concerned about how opening a new card will affect my credit. I have an excellent credit score, over 800, and I’m nervous about damaging that. I’m worried that taking out a new card and having more available credit would hurt my credit score. Is this a legitimate concern?
Let’s take the issue point by point and debunk a few common misconceptions about credit cards, rewards programs, and your credit score.
First, the obvious: Even the best rewards card is a terrible deal if you don’t pay your balance in full every month. Unfortunately, many consumers are lured to these cards by free airline tickets or a $200 gift card but end up carrying debt on the cards at 20 percent APR. Money Under 30 readers know better, but I have to say it: Don’t do this. If you need a credit card for emergencies while cash is tight, find a card with a low APR and forget about rewards
Are credit card rewards a scam or a deal?
You know the saying: “if it’s too good to be true…”
When you stop to think, the fact banks can pay us 1 or 2 percent back for every dollar we spend should raise an eyebrow.
The reality is, we all pay a 2.5 to 3 percent “electronic payment” tax on everything we buy. These are called interchange fees; money the banks charge stores to process their cards. Laws, no doubt influenced by bank lobbyists, are supposed to prohibit stores from charging more to use a credit card or less if you pay in cash. Rewards credit cards simply give us a partial rebate of this tax.
So now, rewards credit cards aren’t too good to be true, but they’re not exactly a deal, either. By using one, you just get some of your money back. If you find a store that gives you a 5 percent discount for paying cash, you should probably take it.
Do rewards credit cards hurt your credit?
Probably not, but maybe.
Our reader shouldn’t worry about opening a new rewards credit card, or even two. Provided she’s out of credit card debt and has an excellent FICO score, she will likely be approved for the card.
As you might know from “Credit 101”, every time you apply for credit it counts as a hard inquiry on your credit report. Hard inquiries stay on your report for two years. One or two isn’t bad, but more than that in a short period can raise red flags and lower your credit score because it implies you’re hungry for credit.
For this reason, anybody with so-so credit or credit card debt should not apply for new rewards cards. Focus instead on timely payments and reducing debts to bring up your score.
Our reader is also concerned about adding new available credit to her credit report. But this can actually be a good thing for your credit score because of the debt utilization ratio.
A factor in credit scoring, the debt utilization ratio is:
Total of credit card balances / Total available credit
For example, if you have two cards with a combined $4,000 credit limit and spend $1,000 on one card, your ratio is 25 percent. If you spend $3,000, your ratio is 75 percent. Lower is better because it shows you are not using a lot of credit.
Assuming your monthly spending stays constant, the more available credit you have, the lower your ratio will be.
Finally, there is one other factor that may impact this reader’s credit score when applying for a new rewards credit card: average account age.
Part of your credit score is determined by how long you have used credit (the time since you open your first account) and the average age of all of your credit accounts. Opening new cards reduces your average account age, which may have a small impact on your credit score.
The bottom line is that there’s nothing inherently bad for your credit about applying for rewards cards as long as you’re in a good place to start with. The hard inquires and reduction in your average account age may cause a temporary dip in your credit score, but in the long-term having more credit may actually give it a boost.