How Credit Card Usage Affects Your Credit Score

There are multiple elements like usage, payment and cancellation that directly affect the credit score.

(Source: Pexels/energepic.com)

Your dreams finally feel like they are within reach. It took you months of overtime shifts and savings to set aside the funds to buy your first home. All that's left is to make a loan application.

And when you do, you're staring at an interest rate that looks much too high. The bank is charging you a higher rate because of a low credit score.

How could it possibly have fallen, you wonder. You've never taken any loans in the past. In fact, you've always swiped your credit card. And that's when you find out that it was the way you used your credit card that pushed your score lower.

A low credit score can make life incredibly difficult when one is trying to take a loan or, in some cases, looking for employment. It takes years of systematic punctual payments to build a good credit score. But a single missed payment can drag your score down.

Credit-card holders need to use caution especially as certain usage can, very quickly, negatively affect credit score. Here are some factors to bear in mind:

Maxed-Out Credit Limit, A Bad Sign

Using one's full credit limit or maxing out the credit card will reflect badly on the credit score. Even though the usage of credit till the upper limit is allowed, full usage is a red flag for lenders, according to experts.

"Using credit to the full extent shows that you are not able to make your ends meet and that you are living on credit," Manish Jain, country managing director at Experian India, said.

In an ideal scenario, one's credit usage should range between 20% and 40%. This is not to say that if it rises above 40%, the credit score will start declining. In fact, a usage of 40–60% will also be acceptable, but the 60% threshold should not be breached, according to Parijat Garg, a credit scoring consultant.

A one-off maxing out of the usage will not dramatically impact the score. But several months of doing this would definitely do so, Garg said.

Also Read: How A Good Credit Score Can Lower Interest Rate On A Home Loan

Missed Payments Will Reduce The Score

Defaulting on a credit-card bill payment is something that will have an instant negative impact on the score. Not paying these dues on time will bring down the credit score that is built over regular payments made over time. This drop in the credit score can take longer periods to recover from as well.

Paying the 'minimum due', which is usually 5% of the total due amount, will not trigger this event. But an interest charge and a late fee is levied on the amount that gets carried forward to the next billing cycle. Missing three payments completely would constitute a default.

"A missed payment would have a negative impact, but the way forward is simple. All you are supposed to do is to simply continue making payments on time," Jain said.

Also Read: Fintech Is Redefining The Future Of Payments In India

Will Cancelling The Credit Card Affect Score?

The simplistic answer to this question is, yes.

This product is usually an individual's introduction to the world of credit. Cancelling the first credit card is not a good idea because one's credit score depends on the active credit history. Cancelling the oldest card would then shift the active history to the next loan or credit card that person took, according to Garg.

Assume that one took a credit card 10 years back. The person then got another one five years back. Cancelling the first card would mean that the person now has an active credit history of only five years — the duration of the currently active card.

This is why banks are keen on getting first-time users of credit cards because the expectation is that these cards will be kept active, Garg explained.

There is another reason a credit score would drop. The credit card is a line of credit. The closure of a line of credit would be viewed negatively when compiling a credit score, according to Garg.

If one has multiple cards, this would still be the case because the credit score is based on one's collective limit. The cancellation of a card would result in the lowering of this limit. And if one keeps the usage the same, it will also result in a higher consumption of the credit limit on an ongoing basis.

For example, if one had a Rs 5-lakh limit split between two cards and the monthly usage was Rs 1 lakh per month. Cancelling one of the cards and bringing the limit down to Rs 2 lakh and maintaining the same usage would mean that one is now consuming 50% of the overall limit compared with 20% earlier.

A good option to consider here is to raise the limit on the card one intends to retain and then cancel the other card, Garg said.

Also Read: Amazon Pay India CEO Urges Action On Connectivity, Fraud To Enhance UPI Payments

Watch LIVE TV , Get Stock Market Updates, Top Business , IPO and Latest News on NDTV Profit.
GET REGULAR UPDATES