Since the holidays are coming up, you’re probably already being bombarded with credit card signups, both at the checkout counter and in your mail. Let’s analyze two offers that constantly confront consumers.
- Cashier: “Hi, would you like to open a Linens ’n Things credit card to save 10 percent today?”
- Junk Mail Offer: “Get 30,000 United Miles when you sign up for the Chase United Mileage Plus Visa Card.”
We’re going to take a look at how to analyze decisions like the one above. How much does opening a new credit card impact your credit score? And how much should you really care, in dollar terms, if your credit score takes a hit?
This may surprise you, but we think your loan appetite over the next 12 months is the most important deciding factor. We explain why this is below.
What goes into a FICO score calculation?
FICO score can range from 300 to 850. The exact FICO calculation is a secret, but there have been quite a few loose disclosures. The factors that go into computing FICO score are as follows:
|Past Payment History||35%|
|Length of Credit History||15%|
|Type of Credit Used||10%|
|Recent Credit Inquiries||10%|
FICO is heavily weighted towards the recent past rather than the distant past
In addition to the criteria above, scores are disproportionately weighted towards recent behavior. If you’ve been paying your cards off on time over the past year, don’t expect past delinquencies to carry quite as much weight. Similarly, a slew of credit inquiries from a year ago really shouldn’t impact you much today, but a couple credit inquiries in the last two months certainly will.
What effect will that new credit card have on your credit?
Opening a credit card will have a positive impact on your credit utilization, because the ratio of total debt to available credit lines will decrease. However, in the short run, it will also bring down the average length of your credit history, as well as increase the number of recent credit inquiries. Nobody knows exactly how much each piece will weigh in, but we’d say this nets out to a very minor negative impact in the short run, and a potentially positive impact one year in the future. The overall effect won’t make a difference if you’re sitting on an 800+ score, but if you already have a limited credit history, this could be enough to move the needle from “average” to “poor” credit, and negatively impact your access to credit.
How much do you stand to gain by opening that card account?
Use your credit card applications wisely. Airline miles are usually worth about 1 cent each, so getting 30,000 miles for signing up is the same as getting $300 in your pocket. Meanwhile, the Linens ‘n Things 10 percent discount is a very different calculation, since 10 percent savings probably won’t be worth as much as an airline card, unless you’re spending $3,000 on bed sheets and shower curtains.
Politely decline any credit cards that don’t offer some kind of upfront incentive. There are too many cards, like the Chase Freedom, that pay $100 or more for you to sign up, so you shouldn’t bother applying unless you can reap those kinds of rewards in exchange for your patronage.
And how much do you stand to lose from a lower credit score?
While everyone tends to focus on interest rates and APRs, the most important factor isn’t the loan rate your FICO score can land you. Rather, it’s the amount you’re planning on borrowing in the near future.
If you’re about to take out a $50,000 home equity loan, your FICO score is going to be much more important than if you’re about to take out a $5,000 automotive loan. Paying a higher interest rate on the smaller loan will mean an almost negligible difference in interest payments, so a few percentage points isn’t really important.
Input #1: FICO & your interest rate
Loan officers generally base your loan interest rate off of a variety of factors. You’ll get a lower rate if the loan is shorter duration (like most car loans), or if it is collateralized (like a mortgage). But the only thing you can really control is the interest rate differential based on your FICO credit score.
As an example, the following table is based off of information from LendingClub’s average 36-month “debt consolidation” loan rates.
|Credit Score||Fico Score||Interest Rate|
[Editor's note: Rates listed in this table are not meant to reflect LendingClub's precise borrowing rates for a given FICO score. These rates were calculated by the author, based on a survey of loans listed on the website. LendingClub's borrowing rates vary greatly based on many factors, including the number of recent credit inquiries, credit history length, the number of open accounts, loan duration, and credit utilization rates. Please see LendingClub's rate tables for more details.]
Input #2: loan amount
When it comes to real dollars out-of-pocket, the biggest swing factor is loan size. Below are a few examples that show how little impact a shift in your FICO score will have for smaller loans:
|Loan Size||Fico Score||Interest Payment per Year||FICO Score is 30 Points Higher||FICO Score is 30 Points Lower|
|$5,000||730||$483||Save $155/yr||Pay extra $223/yr|
|$10,000||730||$965||Save $654/yr||Pay extra $446/yr|
|$25,000||730||$2,413||Save $777/yr||Pay extra $1,114/yr|
Don’t worry about opening that new card unless you’ve got a big loan on the horizon
We believe that opening one or two credit cards each year will have a very small impact on your credit score over the next year. It may even raise your credit score in the longer term if you haven’t held many cards in the past, and if you keep your credit utilization rate low.
If you’re planning on taking out a small loan in the near future, or you’re not taking out any loans at all, seriously consider getting that airline miles card. There’s a pretty good chance the 30,000 mile sign up bonus, which is worth $300, is going to outweigh the increased cost of borrowing, based on our calculations. And many other rewards credit cards offer similar deals you can take advantage of for similar payouts.
However, if you’re planning on taking out a bigger loan, don’t risk applying for any other loans for a good year beforehand. When your loan size exceeds $25,000, it’s possible that the sign up bonus on the credit card is worth far less than the increased borrowing cost of the loan.
– Tim Chen is the CEO of NerdWallet, a credit-card search website.