Welcome to lesson 2 in our five part mini-course on earning points for travel.

If you missed yesterday’s lesson, you can find it here:
Lesson 1: Introduction to Points

In today’s lesson you’ll learn:

– How your credit score is calculated and how banks use your report and score to decide whether to approve new accounts

– How to check your credit report for free and fix any issues before applying for new CC accounts

– How you can get a free personalized credit review from an Abroaders travel expert to help you pinpoint and fix any potential problems before you start applying for cards

Protecting your personal credit is a critical part of earning points for travel. Without strong credit, you won’t be able to earn points from credit card signup bonuses, and that means far fewer opportunites to travel for dirt cheap.

One of the most common questions we get asked by folks just starting out with earning points is, “how do all these new credit card applications affect my credit?” “Won’t my score go down if I open a bunch of cards?”

The answer is that opening new credit card accounts should actually significantly improve your credit over time, but you do need to be strategic about the way you apply for cards to get that result.

You also need to be able to keep your spending under control. You cannot get a return on investment from using credit cards to earn points if you don’t pay off your full statement balance each month. The high interest rates and fees that come with carrying a credit card balance from month to month will completely outweigh any value you get from the points you’ve earned. Only spend what you can afford to pay off right away.

How your credit works

Your credit score is based on the following 5 factors:

35% Payment history
30% Amounts owed
15% Length of credit history
10% Types of credit used
10% New credit

Payment History

The largest component of your credit score is your record of on-time payments. If you do miss a payment, make sure to correct the issue within 30 days, and it shouldn’t appear on your credit report. If you find yourself in this situation, call your credit card issuer right away to talk about the issue. If you are polite and reasonable, they may be able to help prevent a late payment from being reported.

If you have late payments, the severity of the impact on your score will depend on how late they were, how much was owed, how recently they occurred, and how many instances of late payments exist.

Payment history includes the following types of accounts:
• Credit cards (Visa, MasterCard, American Express, Discover, etc.)
• Retail accounts (credit from stores where you shop, like department store credit cards)
• Installment loans (loans where you make regular payments, like car loans)
• Finance company accounts
• Mortgage loans

Public records and collections can have a major impact this category of your credit score. Older items or small amounts will be less severe than recent ones or larger amounts.

Negative factors stay on your report for 7-10 years and may include:

• Bankruptcies
• Foreclosures
• Lawsuits
• Wage attachments
• Leins
• Judgements

Credit Utilization

The amount of outstanding debt is a metric used by lenders to predict how likely you are to default on future payments. Even if you pay your credit cards in full each month, your credit report typically will show the amount of your last statement balance as outstanding.

The credit bureaus also look at your credit utilization ratio on loan accounts such as student loans, mortgages, and car loans, but the place where you can have the biggest impact on your utilization ratio is with your revolving credit card accounts. Take the following example. You have a Chase Sapphire Visa card with a $5000 credit limit. Last month your statement balance was $1000, and then you paid your card off in full.

For that account, your credit utilization was 20% If your statement balance had been $1500, your utilization would be 30%. As a general rule, you should keep your utilization under 30% whenever possible. If you need to spend more on your card during a particular month, you can make an extra payment in the middle of your statement cycle to reduce the balance.

Credit utilization is tracked both on an overall level and on a per-card level. To calculate your overall credit utilization, just find the sum of your balances across all your accounts and divide by your total credit limit. In other words, if you have four open credit card accounts with a total limit of 20,000 and your revolving balance totals $2000 for the month, you overall utilization is 10%.

If you are approved for new accounts when churning credit cards, this section of your score will be positively impacted. Each new account will increase your overall credit limit, so if you maintain the same revolving spending, your credit utilization will improve. On the other hand, closing accounts reduces your available credit and hurts your utilization score.

Credit utilization is the biggest opportunity to improve your credit score in the short term. If your utilization is over 30% on any of your accounts, you can fix the issue right away by paying down your balance. It can take a few days for the payment to be posted by the credit bureaus, but when that happens, you can improve your credit score by as much as 15-25 points.

Length of Credit History

In general, a longer credit history will have a positive impact on your credit score. Credit card accounts may have a significant impact on this category. The age of your oldest account, newest account, and the average account age are evaluated to calculate this part of your score. When churning credit cards for points, it’s important to remember that each new account will reduce the age of your newest account to zero, and also reduce the average age of accounts. You can minimize the negative effect of churning cards by keeping your oldest accounts open. This anchors your average score and partially offsets the negative impact of opening brand new accounts. Remember that the positive impact of better credit utilization (30% of your score) is twice as powerful as the length of credit history (15% of your score). This is why you’ll likely see a significant overall improvement in your credit as you open new cards.

Types of Credit in Use

In general, having more diversity in the types of credit you are using will improve your score. Credit card accounts, retail accounts (like a department store card), installment loans (like student loans), finance company accounts, and mortgage accounts are all take into account in this category. There may not be much you can do to improve this part of your score. In most cases, it doesn’t make sense to take out a loan or mortgage that you don’t need just to diversify your credit report. Closing an account does not eliminate it from this category, so you may benefit from mortgages or student loans even if they have been paid off.

New Applications

A large number of new applications in a short period of time can be a signal to lenders that you are high risk. Consumers with a short credit history will see a relatively larger impact from new applications than those with a long credit history. In general, the impact from new credit inquiries is small. Inquiries or “hard pulls” stay on your credit report for two years, but your FICO score will only consider the last 12 months of inquiries.

Now that you understand the components of your credit score, lets review the potential effects of churning cards for points. Remember that your score is one of many factors that lenders use to evaluate your overall financial health. Each bank and applicant is different, so we’ll focus on identifying red flags that can get you in trouble and general trends.

Now that you understand the components of your credit score, lets review the potential effects of opening and closing accounts. Remember that your score is one of many factors that lenders use to evaluate your overall financial health.

Applying for a new account

(-) Each new application will temporarily reduce your score by 2-5 points. The negative effect will last up to 12 months. More generally, more than 4 or 5 applications in a short period of time will raise red flags.

Opening a new account

(-) Opening a new account will negatively impact the (15%) Length of Credit History component of your credit score. The age of your newest account, will drop to zero, and the average age of all accounts will drop.

*The more accounts you have open, the less your average age will be impacted.
*The longer your total credit history, the less your average age will be impacted.

(+) Opening a new account will positively impact the (30%) Amounts Owed component of your credit score. Your total available credit will increase, meaning you will be using a smaller percentage of your total credit. This is a signal to lenders that you will use credit responsibly

* The more total credit you already have, the smaller the benefit of opening a new account.
* The larger the credit line on the new account (normally cannot be predicted before your application is approved) the larger the benefit.

Closing an existing account

(-) Closing an account will have the exact opposite effect on the (30%) Amounts Owed component of your credit score. Your total available credit will be reduced, meaning you will be using a larger percentage.

(-) Closing an account will have a negative impact on the (15%) Length of Credit History component of your credit score. Existing accounts anchor the average age of all accounts.

Checking your credit score for free

We recommend a free website called CreditKarma to check your credit score. You can see where you stand on all the key metrics we discussed above and identify areas you need to fix before making your first round of credit card applications.

What if you don’t have an established credit history?

There are two steps you can take immediately to start building positive credit history.